Proven: oil companies make more money when prices are low

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

03 April 2016

Business is supposed to be simple: you buy a product at price B and sell it at price S. The difference between S and B is your gross profit per item, P; that is, S – B = P. So far so easy: If you sell n items, then your total gross profit is nS – nB = nP. Everything is multiplied by n; in other words, everything increases – the greater the number of items sold (bigger n), the greater the total gross profit.

Now what would happen if the selling price, S, was reduced: would the total gross profit increase or decrease? Of course it would decrease. The reverse is also true: if S is raised, then P increases.

For that reason, businesses generally, try to keep the selling price, S, as high as possible. The limit for how high S can is set by the buyer! If the buyer refuses to accept the offered price, the business has no option but to reduce it.

The buyer’s decision is based on very many factors, but chief among them are what other sellers are offering and whether he/she has enough money.

If availability of money is the predominant factor, then it becomes necessary for government to step in and regulate/control the prices. This is what happened in the Kenyan fuel sector a few years ago.

The final formular agreed by stakeholders was one that gives a fixed shilling amount of gross profit for the dealers. Consequently, they make more money per litre when selling prices are low than when they are high – a complete inversion of what would generally be expected.

Having participated, albeit in a small way, in the process of developing the petrol price formula, I don’t think that this was intentional; nevertheless, it is a good thing when both sellers and buyers prefer lower prices.

Unfortunately, when I wrote about it in March last year, many readers branded me a sell-out! They claimed that I have been paid by the oil companies to do (unethical) public relations for the industry. Well; I just call the numbers the way I see them!

KenolKobil released its 2015 financial results a fortnight ago and the big media story was that the company almost doubled its profits compared to 2014. The details, however, tell a more interesting story.

The volume of product sold (n, in our simple business model above) went up by 13%, but total sales (nS) decreased by 4%. Obviously, this was due to the steadily decilining prices during the year.

However, the gross profit (nG) went up by 14%! A look at the simple formula, nS – nB = nG, reveals that the only way profit can go up after a fall in sales is if the buying price falls by a bigger margin. In the case of Kenyan oil dealers, the extra push cames from lower cost of finance: lower buying price (nB) means lower borrowing and, therefore, lower interest payments.