Analyzing the reasons and ramifications of increasing gasoline costs
I suppose it’s appropriate that I address the topic of gasoline prices, given the national hysteria over the recent increase in both the price of gas, and the price of crude oil. While I intend to address the matter from several angles, there is one overarching theme that I want to make abundantly clear: the increase in gas prices is a component of many things, including obvious impediments to increasing the supply of gasoline, oligopolistic competition involving a commodity, and expectations determined in part by the fear perpetually drummed up over prices. Arguing that Exxon’s management, or any other oil company for that matter, is evil for allowing such prices to persist ignores the basic logic behind the mechanisms of supply and demand. Furthermore, advocating windfall profit taxes benefits the government, not the people, and brings us closer to a society that advocates government control over consumer and producer control. Remember what you believe in and your basic logic skills before you allow gas prices to stir you into a rage.
A key component in the gasoline hysteria can be attributed to the perpetual fear mongering of media outlets, both national and local. No news program or publication targeted at any market has avoided the subject of gasoline prices. It is more likely that you will hear the current trading price for a barrel of crude oil than the current trading level of any major index including the Dow Jones indices. But what purpose does this serve? Is it really necessary to report the average price of gas nationally when local prices—which are the only prices that matter to the consumer—are posted on virtually every street corner in commercial areas? The answer is obviously: no. The frantic reporting of gasoline prices in the attempt to portray the situation as a crisis rides shotgun for any media outlet, whose m. o. has been reporting the most controversial, shocking, and upsetting news to garner interest and ratings for decades.
The biased reporting indicated its intentions at shocking the public—and insulting our intelligence—in recent stories focused around the ‘significant increase in pawn shop traffic, where individuals pawn cherished goods for gasoline money.’ Unfortunately, the reporting indeed increased the ire of the American public, but failed to insult our intelligence. You see, in an attempt to appear ‘unbiased’ in reporting the news of the day, almost all media outlets avoid critical analysis of their own reporting. However, no analyzing one’s own reporting not only avoids bias, but rather, takes a benign story and allows unreasoned interpretation and bias to creep in. If one takes the time to consider why some people would be pawning more items for gasoline money, the relationship is fairly obvious. No report claims that new traffic to pawn shops has increased, and one can conclude that individuals who would consider pawning valuables and possessions in the first place are likely to be the same type of person who is incapable of dealing with a significant price change in a commodity, and must resort to drastic action in order to compensate for their own lack of foresight and restraint in spending.
In reality, reporting the increase in gasoline prices as a surprise is about as misleading as it gets. The United States has been set up for a massive increase in gasoline prices for years, and I’m not the only one who finds it surprising that the increase hasn’t been more significant. Consider the factors affecting demand for gasoline: an increasing population in the United States which is correlated with an increase in the number of cars on the road, a residual propensity to drive long distances rather than fly due to 9/11 and other airline disasters, and an increase in demand and sales for cars that produce less miles traveled per gallon of gasoline. Also consider the fact that gasoline is a commodity, which indicates it is very price inelastic. Now, consider the factors affecting supply: no increase in physical capacity of domestic refineries, a block on domestic crude oil production, and temporary shortages or outages due to unavailable additives (to be considered later). This means that the supply of gasoline produced can only grow at a very limited rate, if at all. The situation as I’ve described it can be modeled as in the graph below, where S1 and D1 indicate market supply and demand respectively. Notice that demand has been illustrated to reflect inelasticity, and though it may be appropriate to model supply in similar fashion, it has been illustrated to show that output can increase, but only at a substantial premium to the consumer. The appropriate changes in demand and supply mentioned above have been similarly reflected in D2 and S2 respectively.
Three or four years ago, the market was trading at price P1. The same factors were all in place at that time, so it was pretty clear to most economists that the price of gasoline was bound to go up if the supply chain was put under any duress, or if the demand grew significantly. Today, gasoline trades at a price in line with P4, reflecting both the increased scarcity and increase in demand. In the short-run, once refineries have managed to master shipping ethanol blends in the same cost efficient manner they shipped blends with ATP additives, the price will recede to the level P2. That being said, it seems clear to me that the days of $1.50/gallon gasoline are long gone. Furthermore, the prospect of $2.00/gallon gasoline is also pretty unlikely in the current market climate. The only way we will see substantial price reductions in gasoline will require a blend of things conservatives and liberals have been talking about for years: a decrease in consumption and reliance on gasoline that the liberal left demands in environmental interest, and an increase in refining capacity and domestic crude production from areas like the Gulf of Mexico and ANWAR as conservatives have said.
Most people don’t want to consider the facts as I’ve laid them out, and would rather react to the situation in an irrational manner that blames ‘greedy’ oil companies for posting large profits in the face of increased costs. Those same people are the first to refuse to acknowledge that the average profit margin for Exxon-Mobil on a gallon of gasoline has grown by less than a penny over the past year to $0.09/gallon, and that the majority of Americans experience a benefit from these profits as many of them are invested in Exxon-Mobil’s publicly traded stock, either through direct purchase, mutual funds, or pension plans managed by their employers. So, while a $8 billion profit sounds excessive, one must understand that the profit is not derived from price-gouging, but rather, from the massive volume of business, and at the benefit of all its investors.
However, the final thing I will point out for consideration is the mechanism to determine the appropriate release valve for prices. There are two options, as I indicated before. The liberal route involves curtailing demand, which could involve conservation, substation to alternative fuel, or a blend of the two. The conservative route involves increasing our capacity of crude production along with an increase in refining capacity as well. Yet, neither solution will yield instant results. Alternative fuels have taken and will continue to take time to perfect.
Increasing refining capacity will similarly take time, given the amount of infrastructure that would need to be developed, along with obtaining the appropriate permits and clearances within EPA guidelines. In reality, neither route alone will succeed, it will probably take a blend to increase the independence and cost-effectiveness of energy in the U.S. A blended approach hedges against other shocks on supply, especially given possible irrational actions from some of our lesser crude oil suppliers including Venezuela and Iran.