Availability of oil refinery capacity seems to be an important determinant of oil prices.  The chart shows the relationship over the past 20 years between international crude oil prices (on the vertical axis) and excess refinery capacity (on the horizontal axis).

The relationship suggests that prices have been responding to the elimination of excess refining capacity as demand has been growing without a corresponding investment in processing capacity.

Over the year to the March quarter of 2006, U.S. after-tax profits rose by a healthy 17.6%.  In the six years since the turn of the century, profits have expanded at an average 16.5% a year and, as the chart suggests, their ascent is showing few signs of flagging. 

While there have been many contributing factors to this outstanding performance, two are worth highlighting for their continuing impact.

·         Firstly, there has been a disciplined approach to business planning. After the experience of the previous cycle, managers have refrained from committing to employment or investment unless the need has been clear-cut to make subsequent adjustments smoother and less damaging to profit outcomes.

·         Related to this, cost control has been exemplary with highly competitive global markets enforcing a long term change in culture. 

One indicator of the extent of corporate cost containment is available from the macroeconomic labour productivity and cost measures released by the US government.  Real unit labour costs, shown in the second chart, takes account of three determinants of profit: wages, labour productivity and prices. 

If labour productivity (i.e. output per hour worked) is growing faster than wages, unit labour costs are declining and operating profits should be rising.  

If, at the same time, the price a business receives for its output is rising faster than unit labour costs, real (i.e. price adjusted) unit labour costs will be falling and operating margins should be widening. 

The most recent U.S. data, for the period over the year to the March quarter, showed productivity up by 2.5% and hourly compensation rates 2.8% higher within the non-farm business sector of the U.S. economy. 

With labour costs running slightly ahead of productivity increases, there was a small nominal cost squeeze. However, this was more than compensated for by a 3.2% rise in prices, a higher rate of increase than at any time since the early 1990s. 

This commercial windfall resulted in a 2.8% decline in real unit labour costs - taking them below levels reached in the mid 1990s at the time of the previous cyclical peak in U.S. business profitability. 

While these statistics are a little outdated insofar as they are now five months old - numbers for the second quarter will be available at the end of August - they offer an insight on three issues. 

·         Although the value of the accumulating profitability might have been muted by a long succession of interest rate rises, it provides an important determinant of long term market value likely to become more evident as the next downcycle in interest rates occurs, as it inevitably will. 

·         The new business culture which first became evident in the early 1990s and which has resulted in such profit focused managers seems to be a continuing feature of U.S. economic and business conditions. 

·         While companies have been relying more on prices recently to keep profits growing strongly, they appear to have taken advantage of conditions opportunistically rather than being forced to use prices as the only way to achieve better financial outcomes or as the sole means of protecting their positions. 

The last of these three has broader implications.  If business remains capable of delivering acceptable profit outcomes with only limited recourse to more aggressive price settings, policy makers can be more relaxed about upward pressures on inflation. 

thebigpicture is published by thebigpicture Economics (ABN 71 040 787 936). The author, John A Robertson, while working in Australia, London and New York, has had over 25 years experience in international financial and commodity markets, corporate strategy, financial and business evaluation and government policy.

As Chief Economist and a director of a leading Australian investment bank as well as a top-rated institutional equity analyst, he has marketed investment advice in all the major international financial centres.  As a professional economist, he was also a senior member of John Howard's personal staff when the current Prime Minister was Commonwealth Treasurer.

His work as a senior corporate finance executive in several public companies in the mining, consumer goods and IT industries complements a unique perspective in analyzing Australian companies and the environment in which they operate.

John Robertson provides investment advisory services to wealth managers including advice on asset allocation methodologies, portfolio construction and client communication programmes. He also advises companies on their capital market communications and financial strategies.

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