Gas Prices Soar: Markets or manipulation?

April 30, 2006 • Commentary
This article appeared in the San Diego Union‐​Tribune on April 30, 2006.

So why are gasoline prices soaring into the stratosphere? One explanation is that oil companies are exercising their market power (enhanced as it was by the wave of mergers and acquisitions that hit the oil industry during the 1990s) and are manipulating the market to gouge consumers. Another is that gasoline costs more today than yesterday because the cost of crude oil and various fuel additives such as ethanol have been on the rise.

Both conspiratorial and cost‐​based supply explanations are unsatisfactory because they ignore demand. Gasoline prices are high because consumers have decided that it’s still a “good deal” given the alternative. Until that changes – or until new supplies are offered – prices will remain high indefinitely.

A good analogy to what’s going on in the gasoline market can be found in the housing market. Home prices are not dictated by construction costs or by back‐​room meetings of real estate executives. They are established by auction. Prospective buyers rarely think about how much houses cost to build.

Instead, they think only about whether a house is worth more to the buyer than the price asked by the seller.

In gasoline markets, prices are likewise established by auction. Those auctions occur in a multitude of regional spot markets. Oil companies generally sell gasoline to their franchised service stations at the spot price plus transportation and various business‐​related costs. Service station owners then post whatever price they like, but given competition, they can rarely charge much beyond their acquisition costs.

A few observations follow from this analysis. First, “Big Oil” cannot manipulate wholesale oil and gasoline spot markets. Accordingly, the prices we’re seeing at the pump are untarnished by corporate collusion or price‐​fixing – the conclusion of literally dozens of governmental and academic investigations of oil markets since the 1970s.

Second, production costs enter into the equation but only in the sense that producers are loathe to sell at a loss. Beyond that all bets are off. Producers sell at what consumers in spot markets are willing to pay regardless of how much it costs to lift that oil from the ground or refine it into gasoline. Third, there isn’t an economist alive who would argue that pricing via auction is a bad economic idea. Gasoline – like houses – is not unlimited. Allocating scarce goods and services to those who value them most is the very definition of economic efficiency.

And generally, people do not view pricing via auction (in essence, pricing based on willingness to pay) as unfair. Sure, we all need gasoline, but we all need food, housing and lots of other stuff, too. Why do we rail against “price‐​gouging” oil executives – who are simply charging auction prices – but not against price‐​gouging home owners or greedy eBay merchandisers?

One might reply that the difference is that we might all take our turn playing the role of “gouger” in housing markets but that we’ll never have that opportunity in oil markets. But that’s not strictly true. There is no person walking around with the first name “Exxon” and the last name “Mobil.” ExxonMobil is simply a collection of stockholders. If you want to join their party, buy stock and feed your inner greed‐​merchant. Or start a new oil company.

If you do, however, you’ll find that the grass isn’t nearly as green on that side of the economic fence as you probably thought. Despite the arresting raw earnings figures, profits in the fourth quarter of 2005 (the most recent quarter for which data is available) haven’t been all that impressive for the denizens of “Big Oil,” ranging from 6.8 percent at British Petroleum to 10.7 percent at ExxonMobil. Goldman Sachs reports that return on investment capital in the oil business from 1970–2003 were less than the U.S. industrial average.

But let’s get back to price in the here and now. Why have consumers bid up the price of gasoline to a national average of $2.90 for a gallon of regular today but not last year? First, refineries have to at least cover their crude oil costs. Crude oil spot prices are higher this year (47 cents per gallon) than last, even though inventories are well above their average because buyers of oil fear future disruptions. In short, some people in the market are bidding up the price of oil and stockpiling it because they fear future prices will be even worse.

Second, the supply of gasoline is less than last year. Gasoline production in April averaged 450,000 barrels a day less than the year before because of production capacity still off line from Hurricane Katrina and postponed refinery maintenance. The switch from MTBE to ethanol is constraining supply as well. The net result is that gasoline supplies are tighter this spring than would ordinarily be the case.

Accordingly, if you want gasoline, the price you’ll have to pay in spot markets to get it is higher than it was before. It’s a simple story to tell. But unfortunately, it’s not one many politicians want to tell: Don’t like today’s gasoline prices? Then cut back on how much you buy. It’s the only sure way to reduce prices – at least until a new wave of supply hits the market.

Will consumers respond? To some extent, they already have. Consumption has been actually declining of late and sales of gas‐​guzzling SUVs are sharply down from where they were a year before. The contention that motorists have no choice but to buy gasoline no matter what the price is nonsense. Consumers can buy more fuel‐​efficient cars, cut back on non‐ essential trips, car‐​pool to work, abandon cars for buses and commuter trains, or move closer to mass transit stations or place of work if necessary. They can even ride bikes.

Will producers respond to today’s (relatively) fat profit margins with new supply? If past is prologue, they almost certainly will. Oil markets – like most commodity markets – move in distinct boom‐​and‐​bust cycles. During booms, oil prices increase dramatically until investments in new supply flood the market. Oil prices then crash and only modest investments in new supply occur over the next decade or two as producers draw down the excess production capacity produced from the last boom. Once excess production capacity is worked out of the market, prices increase, investors respond by pouring money into new supply in order to capture profits, and the entire process is repeated anew.

The current oil price spiral should be seen in the context of past oil price spirals. The present price spiral is occurring right on schedule – 25 years since the peak of the last price spiral, which occurred in 1981. And past does indeed appear to be prologue on the supply front as well. Analysts at Cambridge Energy Research Associates calculate that investments in oil production now in the economic pipeline will increase world crude oil production by 25 percent by 2015 and even more thereafter; the largest increase in world crude oil production in both nominal and percentage terms in history.

It may take some time, but high prices will almost certainly induce more supply and conservation at less cost than any conceivable governmentally imposed “energy plan.” The danger isn’t that Congress won’t take our word for it. The danger is that by doing everything in their power to force prices down regardless of the underlying market realities, politicians will make matter worse than they already are.

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