Big, Bad Oil

No matter how much I write about fuel prices and economics, similar questions keep popping up. In my 30 years as a petroleum distributor, I've never seen prices more volatile. 25-30 cent daily price swings are not uncommon. As gasoline headed towards $7/gallon here in California, the usual story lines started appearing. Are the major oil companies price gouging? Are the profits being earned by major oil "excessive"? What can the government do to lower gas prices? It's ironic that in July of last year I published a post on the inelastic demand for gasoline (please take the time to review the 17 July 2021 post, as this post will hinge on the elasticity of demand as well). Now, almost exactly one year later, President Biden throws out a post on 4th of July weekend accusing independent service stations of price gouging. In essence, the President of the United States is accusing ME of price gouging! "I have met the enemy, and he is me."

Hopefully, my response here will be economically reasoned, and I invite my fellow economists to critique en force. The analysis begins with the understanding that the market for crude oil, and hence gasoline/diesel is an international market. It's not perfectly competitive on the supply side (as several players (e.g. Russia) are large enough where they can affect the price); however, with the recent addition of the US as a major producer, the price coming from the marketplace is pretty darned competitive. As hard as we try to move to "cleaner" energy, it's clear that there are few substitutes for petroleum based products. Few substitutes, means the demand for oil/petroleum products is INELASTIC (more on this to follow). Here in California, the state is mandating that all petroleum be eliminated in the next decade or two. Economics hinges upon the fact that all economic players respond to incentives. What kind of incentives do these proclamations provide to petroleum suppliers? Would you want to own a refinery in California, knowing that you will be forced out in the next 20 years? Would you be inclined to make any improvements to the one you already own? This isn't rocket science -- the Phillips 66 refinery in Santa Maria, just miles from my home, is slated to close! Now realize, there are only about a dozen or so refineries in the state that can produce the state's gas formulation, and we've got a problem brewing. As California goes, other states will follow. As a result of Covid, and the initial international gasoline demand destruction it created, many refineries chose to shut down. Given the negative incentive just discussed, several will NEVER reopen.

What does all of this mean for gasoline prices? That requires an analysis of the Ukraine war and what that has done to world oil prices. Russia was producing about 10% of the world's crude oil, and was a major exporter of refined products (gas, and especially diesel for Europe). As international boycotts have limited Russia's ability to supply the market, the supply of crude oil was significantly curtailed. In microeconomics, we speak of this as a reduction in supply. The upward sloping supply curve will shift to the left. I didn't want to gum up the nice visual I found on YouTube, but if you drew an upward sloping supply curve intersecting demand at $3.00/gal, and then shifted the supply curve to the left until it intersected the demand curve at $6.00, you would have the desired effect (a decrease in supply, is a leftward shift of the supply curve). This basic analysis was discussed in my post from July of 2021.

Now, add to the discussion the concept of total revenue as it relates to elasticity. Total revenue is simply Price X Quantity. In the illustration above, the total revenue at $3.00/gal is $15, and the total revenue at $6.00/gal is $24. Why did total revenue rise just because the price of gasoline rose? This ALWAYS happens along an inelastic demand curve. Why is the demand curve for gasoline (at the international market level) inelastic? As I stated previously, there are still no close substitutes for petroleum products! With US refineries now running at about 95% capacity, and total revenue substantially higher, what do you think has happened to their profits? Again, not rocket science, they have increased substantially. Did any of my discussion above involve major oil companies and refineries conspiring to raise prices? Hanging out in smoke filled rooms, deciding to stick it to consumers? No! Major Oil is simply responding to the international marketplace! They have a product which the world needs right now, and the price is substantially higher now than it was before Ukraine. By the way, no one ever mentions the major oil companies and refineries losing their shirts when prices fall. In addition, I have first hand knowledge of the behaviour of big oil. The major oil companies do not get along at all. I get prices from several major oil companies daily. If one lowers their price, the rest follow suit so as not to lose out on any sales that day. However, if one goes up, the rest resist, unless market forces are pushing them in this direction. The idea that fiercely competitive pricing analysts are colluding is pretty ridiculous. Furthermore, don't you think we would know if they were colluding on price? It's illegal and it wouldn't take too long for some whistleblower to rat them out.

The idea of price collusion at the independent service station level gets even more ludicrous. 60% of gasoline service stations are mom & pop operators. Even if they are flying a major oil companie's brand (think Chevron), they are still independently owned/operated. The major oil companies fled the retail market 20 years ago, as it was not profitable -- they chose to stick with production and get out of retail! At the retail level, gasoline is very competitive. In fact, if you consider the demand curve that an individual station faces it is highly ELASTIC! Now wait a minute. Didn't I just say that the market for gasoline is INELASTIC in the preceding analysis? Absolutely, but as you move down the retail chain, things change. Why? Consider an individual station. If Johnny Quick raises his gas price, do his customers have any options? You bet! If Johnny Quick's price it too high, customers will flock to Costco! In microeconomics, we say there are many substitutes (in the consumers mind) for Johnny Quick gasoline. Many substitutes means ELASTIC demand. No single player has the ability to affect the market price, whatsoever. If I attempt to raise my prices too high (as Biden assumes), Costco is always right there to keep the price low! I lose my customers as they switch to Costco! President Biden is basically saying that Costco and all the independent operators in the area are suddenly cooperating to raise prices. Hogwash!! One of my former retail customers told me that if he was even 5 cents out of line, he would lose 20% of his customers! That's the definition of an ELASTIC demand curve!

At this point, I hope to have convinced you that the major oil companies have not conspired to raise gas prices. Neither have the independent operators, so who is to blame? Blame it on free market economics! Have restaurant operators conspired to raise menu prices? No. Have dairy producers conspired to raise milk prices? No. The free market system uses price to allocate, in the most efficient manner, scarce goods and services. The "invisible hand" of price, does not care about profits, consumer feelings, political party affiliation, etc. Consider the following example I actually witnessed: Over 10 years ago, California was not in a drought, but the middle of El Nino. It rained so hard that the Monterey Peninsula, became an island! The Salinas lettuce crop was destroyed. Why does this matter? California produces 90% of the lettuce grown in the US! What do you suppose happened to the price of lettuce? Well, it went from $6/carton to over $34/carton. So what you say? I just so happened to have customers in the Central San Joaquin Valley that also grow lettuce. Their fields were not destroyed. A good lettuce field can yield upwards of 1000 cartons/acre. In a "normal" year, one could expect revenue of approximately $6000/acre, but now it was $34,000/acre. I have customers growing hundreds and sometimes thousands of acres of lettuce. On 500 acres that's revenue of $17 million ($34,000/acre X 500). If all of the added revenue that year went into the farmers pocket, that's somewhere around $14 mil in excess profits! Lettuce growers actually stationed armed guards on their fields that year. So, what's my point? The free market does not care if you earn a profit, or not! It simply insures that buyers and sellers are matched efficiently so that the market is cleared of product. If you loose, so be it, or if you gain, so be it. There is no such thing in economics regarding "excessive" profits in the short run. If profits are too high, competition will come in and take them away. So what is big government to do? Certainly, there must be something Uncle Sam can do to help the poor consumer?

First of all, the cardinal lesson is: "mess with the markets at your own peril." Long before I was an petroleum jobber, I was teaching economics at the Air Force Academy. There was an interesting news article about the Mayor of Washington D.C. trying to come up with ideas for raising city revenues. He struck upon the genius idea of levying an additional tax on gasoline sold in D.C. Sounds good right? Raise the price on an INELASTIC demand curve, and reap the total revenue gain, right? He'd obviously had just enough economics to make himself dangerous. Just think about it, there are many substitutes for D.C. gas -- Maryland gas, Virginia gas, etc., etc. The demand curve for D.C. gas was actually ELASTIC. Within weeks of implementing the tax increase, gasoline sales had plummeted 20%! One third of the service station employees in D.C. were laid off. Gas tax revenue to the city plummeted as well. Months into this debacle, the mayor cancelled the tax, but at what cost?? This particular mayor became notorious in economic circles for this debacle, but was more notorious in political circles. His name: Marion Barry (Google him, if that name doesn't ring a bell).

What other genius ideas have politicians come up with to ease the pain at the pump? Consider the great state of Hawaii. They have attempted, numerous times, to enact price controls. Don't like the price at the pump? Just pass a law to make it lower! Sounds great right? First of all, this is government control of the marketplace. That is one of the central tenets of socialism -- Uncle Sam knows best, not the marketplace. Unfortunately, our economic system was based upon freedom, and competition. Markets are very "efficient" at allocating goods and services (I spent most of my graduate studies proving the efficiency of the competitive marketplace, I'll spare you the details), and governments are not! Needless to say, everytime Hawaii enacted price controls they were a disaster. Oil companies diverted oil & fuels away from the island because they could make more money elsewhere. The result: Actual product shortages. You got it, gasoline ran out, and the price controls were lifted. The US tried to regulate gasoline prices in the 70's and got the same result -- shortages and long lines at the pump.

What about taxing "excess" oil company profits? Again, this sounds good, doesn't it? What incentive does that send to the marketplace? Invest in more oil production? Certainly not! At the very instant when we need more production, the government pursues ways to decrease production. Does this shock anyone? Any attempt by governments to intervene in free markets usually ends in failure. I believe it was Milton Friedman who asked the question: Is there any other economic system that can deliver the results of a free market economic system? Answer: NO. Has socialist Russia, Venezuela, Cuba, dare I say France, produced any notable economic achievements? Apple, Google, Amazon, Netflix, etc., etc., were not birthed in the den of socialism. Why not? Because economic freedom reigns supreme. We may not be all that we can be today, but we are orders of magnitude better off than we would be under any other economic order. For those of you who dream of a utopian existence where everything is "peaches & cream," dream on...

Shame on you Mr. President for your utter lack of economic understanding, and your attempt to shame independent service station operators into doing your bidding. I never thought I would see the day.