My spin on oil prices, oil companies and price gouging

High gas prices due to high oil prices, and now record profits by the oil companies, are on everyone's mind. The oil companies will have you believe that the prices and profits are totally driven by the market, while the politicians looking to get some good press for their reelection bid will tell you that the oil companies are making a killing. Truth be told they are both right and both wrong.

The oil companies say that the price of gasoline (and the crude oil that is a major part of the price of gas) is based solely on supply and demand. For the most part, they are right on that part. The price of any product, in the absence of any kind of price or consumption controls, is determined by supply and demand. Economists use a supply and demand curve to illustrate this, and its a pretty simple concept to understand. If the price for something is very high, producers would like to produce more but consumers want to buy very little. At the other end of the spectrum, if the price is very low, consumers want to buy a ton but producers want to sell little to none since they make no money there. In the real world you seldom see either extreme, and the true amount supplied and demanded is somethere between the two. In effect, supply and demand adjust until they are in equilibrium. Over time the price will still fluctuate due to either supply or demand spikes, but generally will stay within a given and established range untli something comes along to change that consistent pattern.

In the case of the supply of gasoline, the oil companies say that environmental rules and low profits in the past have restricted the building of new refineries. That is partly true. Environmental laws have gotten tougher in the past couple of decades and the restrictions on building a new oil refinery would be considerable. Low profits in the past and low gas prices have reduced the willingness of oil companies to make an investment in new plants. Also, with the very American tradition of "Not in my back yard", this makes new the building of new refineries even more unlikely. By investing in such a plant, a given oil company would produce more product, potentially driving the price they receive down further, meaning such an investment in a new plant would be foolish from a purely economic standpoint. There have been basically no new major oil refineries built in the past couple of decades in the US. A recent story in the Kansas City Star reported that in roughly that time frame (I believe over the past 2 decades), the demand for gas has increased 38% while supply has decreased about 9%. Factor in added demand from countries like India and China, and its no wonder that prices have increased. Then when you add in supply shocks and disruptions such as Hurricane Katrina, that just magnifies the problem. The numerous market specific blends of gasoline further compound the problem. While I myself agree that some of these blends of gasoline do help, there are clearly too many right now. That market proved that point when the rules were temporarily suspended when gas prices were at their peak regarding these blended fuels, and gas prices dropped almost overnight as a result. Again, some of these blends may be warranted, but there needs to be fewer different formulas used across the country.

Prior to the recent run up in oil prices, getting all the red tape and government regs ironed out to build a new refinery would have been an uphill battle for any major oil company, especially with the current "Not in my backyard mentality" that most Americans seem to have nowadays. Regulations, especially from the EPA, have made it almost prohibitive to open any new refineries. Also, the oil market has been the scene of many rounds of consolidation, with many refineries closed in the process. Oil companies closing refineries is really not that much different that GM, Ford or Chrysler (or any other company for that matter) closing plants to reduce excess capacity. When gas was cheap, some oil companies went out of business, many consolidated and basically all of them made less money. So they closed refineries to reduce supply, and now with demand higher, you get a supply disruption like Katrina, and BOOM! you have big price increases. One big difference though, is that while the auto companies have openly admitted closing plants, many of the oil companies have not been so forthcoming with their facility closings. They have the same effect and are done for the same reason, but its as if the oil companies don't want you to know that they are trying to restrict supply to raise the price. On the other hand, people aren't up in arms when the big 3 auto makers announce that they are closing plants, so big oil could argue that they have that same right to look out for the liveliehood of their own business. In a democratic and capitalistic society such as ours, any business has the right to make such decisions.

Another big difference between the oil industry and manufacturing is that with manufacturing, most plants can increase volume or add another shift to increase production, but many refineries are already operating at capacity. Once refineries are at max. capacity, there is not much a producer can do to lower the price. From that point, demand takes over in controlling the price. As a country, even when gas prices hit about $3 a gallon, consumption did not really seem to drop off much. Once you get above that amount though, you may see demand start to wane, at least a little bit.

Part of gas price increases (at least in the short term) are due to the buying habits of many in this counrty. Many people top off their tanks when they hear prices are going to go up, and this further drivers the price up due to the increased demand. So by topping off your tank, you are basically making the gas prices go higher and do so at a faster rate. I personally will get gas in such a situation if I have less than half a tank left, but otherwise I don't bother. By topping off our tanks, we just make the price increase higher and sooner than if we just act normally. Unless I know the price is going up 10 cents or more a gallon and I need well over half a tank, I just wait until I need gas to bother filling up the tank.

Unfortunately, when gas prices rise, the retailers make less profit as the oil companies make more money. But an angry public tends to blame the first one they see, which is the retailer that sells the guess. Some of them are owned by the oil companies, but some of them are not (including the market leader in this area, QuikTrip). Their margins on gas are pretty thin, and sometimes they will actually absorb part of a price increase, at least for a short period to keep gas from getting too expensive.

So how do we fix this problem? Well, as in any case like this, you either have to increase supply or decrease demand to get the price to fall. Increasing supply is pretty much out of the question as far as crude oil is concerned. From the info I have gathered, crude oil production is just about maxed out at the moment. When you factor in the political instability of Iran and Venezueala, that supply is even more uncertain. But the supply of refined gasoline could be increased if more refineries are built in this country. However, before any oil company is going to invest that kind of money, they will likely require either massive subsidies or tax cuts from the government to do so. Right now if a large oil company decided to build a new refinery, it would cost them billions of dollars (the cost of building the new refinery and to meet all of the environmental rules and regulations that go with a new refinery) and would only really pay off if the demand would pick up enough from the lower price of gas resulting from the extra supply of gasoline resulting from the new plant. If the price did drop by say, fifty cents a gallon or so, you would see a spike in demand. But its hard to say if that would be enough to pay for a new refinery. Also, one refinery would not likely make anywhere near that big of an impact on supply. Otherwise, such an oil company would basically be spending billions of dollars to lower their margins on gasoline. Obviously no oil company is going to want that as a result, so a new oil refinery or refineries seems less likely. You could see more new indepenedent small and medium sized refineries if the prices stay at this level, and that could ease prices somewhat, but I don't know that it would do more than lower prices a few cents a gallon.

Ethanol and other alternative fuels also play a part here. Ethanol helps because ethanol blends have at least 10% ethanol, meaning they use that much less refined gasoline. But they have to pay for the ethanol, and demand is outstripping supply there as well, and if corn prices spike, that could make that situation even worse. Ethanol supply is gradually increasing as new plants come on line. There is some hope of finding cheaper sources of fuels for ethanol than corn, but none of them are really in full production yet or are likely to be any time soon. Wider adoption of ethanol could help the situation a little bit, and does have the added benefit of reducing our dependendence on imported oil, a potentially big factor if an intertnational crisis reduces our crude oil supply.

Every time gas prices climb close to $3, the public gets pissed off, and politicians seek out the opportunity to look good on national tv, even if there is not much that they can do. Congress holds hearing and investigates collusion on oil and gas prices, but they never find anything. Congress can pass a windfall profits tax on the oil companies, and that is possible in the future if gas prices go higher and oil companies continue to have record profits. I continue to be amazed that the oil companies do absolutlely nothing to help their case with the American public regarding high oil prices instead of just talking about how its all based on high crude oil prices and that there hands are tied, but those arguments seem pretty hollow to the average consumer who is paying over $3 a gallon for gas while oil company after oil company posts record profits. Picture if one of the major oil companies decided to lower their refining margins on gasoline for a month as a gesture of good faith to the American consumer. They would lose some money in the process but would go a long ways toward gaining the support and good faith of an American public that is growing ever skeptical of the oil industries arugment about high oil and gas prices. If the public gets too pissed off, they may create enough pressure on Congress to pass the threatened windfall profits tax on the oil industry. I would be against that since it not only interferes with the ability of these companies to do business, but it also would not necessarily lower gas prices at all.

So what do we do?

Here are a few ideas:
1.) Reduce demand- drive less, use public transportation, etc. This would work but is very hard to make happen with a public that is used to driving everywhere in their own cars.

2.) Use more ethanol- this helps up to a point, until demand for ethanol goes high enough to raise the price of corn enough to negate this. But it does reduce the dependence on foreign crude oil, and that is a good thing.

3.) Tougher mileage requirements for cars and trucks (have to thank my big brother for this point, its one of his favorite) and don't exempt any vehicles for it. This won't solve the problem but will help ease it.

4.) Have fewer blends of gasoline- This drives up the cost of gasoline considerably in some markets for a questionable benefit. I am not arguing that they are not necessary, but there should only be 2 or 3 blends. That would lower refining and transportation costs and lower prices for all of us.

5.) Encourage the building of more refineries, especially smaller and medium sized ones that would be more likely to be locally owned, instead of being owned by giant companies. This would help keep prices on check, and also might the economies since smaller refineries were probably create more jobs than the builidng of one big refinery, as well as be less of a fight to get it built.

As far as the oil companies go, my biggest gripe with them is that they still fail to admit that they played a big part in gas prices going up (although they are not solely to blame). Over the past couple of decades, they have shuttered a number of refineries. This reduced the supply of gasoline, ensuring that as the demand for gasoline increased, the price would rise more rapidly, and it has indeed done that. Again, in virtually every type of industry, supply cuts are made when there is excess supply (which always lower prices and therefore margins), and this is really no different that that, except for the fact that high oil prices affect all of our pocketbooks on a weekly and montly basis since we all use gas. High oil prices can also be a drag on the economy as well.

In the long run, unless prices stay this high for years, I think the major oil companies will not build any huge new refineries, but you will see some smaller ones pop up, especially those that are independently owned. At least those will help some local economies out. There will be more emphasis on alternative fuels and gas mileage.

Beyond that, only time will tell.