Gasoline prices are up again. That frustrates people and leads them to wonder just what is going on. I’m no expert on the oil industry, but a few economic explanations are possible. Which you find most convincing will depend greatly on how you view the world.
The first theory is one of abuse of monopoly power. There are a limited number of big oil companies that dominate production, refining and marketing. Each has some degree of market power, and if they collude, overtly or tacitly, they can restrict sales and raise prices.
Because of the nature of demand for gas, the large price increase more than compensates for the modest quantity decrease. Oil companies’ revenues soar. Costs are relatively fixed and profits soar even more. Greedy corporations that have held inordinate power since the days of John D. Rockefeller are raping the consumer, many believe.
There are a few problems with this view, however. There are more companies in the oil industry than in other sectors where we don’t perceive abuse. The market share held by the traditional oil companies is shrinking as national oil companies in oil-producing nations grow.
Crude oil, gasoline and diesel fuel are relatively uniform products. It is harder to collude to raise prices with such products than with differentiated or branded ones.
Moreover, big-company power is not enough to save the industry from periods of low profits. Profits are extremely high now but were comparatively modest through much of the 1990s. Refining was so low-margin that many major companies got out of that business entirely.
Over the long run, retailing is extremely competitive. Stations often make more money on convenience items than on gas. So there are some holes in the abusive monopoly argument.
Another explanation focuses on episodic shocks – political troubles in key oil-producing countries, natural disasters and refinery breakdowns – and how they interact with supply and demand for liquid fuels. This is the industry’s standard explanation and one favored by many economists.
In markets, a key question revolves around what economists call “elasticity.” This involves the degree to which the price of a product reacts to changes in quantity or vice versa. This applies both to supply and demand.
Demand is the value consumers place on a product. What quantities are they willing to buy different at different prices? If a change in price produces little change in the quantity bought, demand is inelastic. If the quantity changes greatly, demand is elastic. The same is true for supply – producers’ willingness to sell different quantities at different prices.
Demand for gasoline, diesel and jet fuel is very inelastic, especially in the short run, because these products are necessities for most people and there are no good substitutes. Supply is inelastic because of the large investments and long lead times necessary to develop oil fields or build refineries and pipelines.
When supply and demand are inelastic, very small shifts in supply caused by external factors – politics, weather, or refinery breakdowns – cause inordinate fluctuations in price. So can overt monopolistic manipulation. So do seasonal shifts in demand.
Political factors clearly are at play in the Middle East, Nigeria and Venezuela, although they are no more severe than six months ago, when prices were lower. Refineries have shut down for repairs unexpectedly in Texas, Oklahoma, Wyoming and elsewhere. And the summer driving season is starting.
Do these factors explain the large price surge over the past few weeks? I don’t have the expertise to tell. My experience in developing countries with high inflation taught me one thing, however. Competition is much less effective in volatile markets fraught with uncertainty than in stable ones where every seller and every buyer knows what their options are.
Decades ago, when gas cost 31 cents a gallon at many stations, cash-strapped college students like me knew where to get it for 29 cents. The same was true more recently. When prices hung around $1.29 for months, many people knew where it was available for $1.24. Price-conscious consumers could drive to get a bargain.
But when prices are going up or down 20 cents in a day, it is much more difficult for drivers to know where the deals are. Internet sites can lower search costs, but these are still not widely used. The mentality becomes one of “better fill your tank before it goes even higher.”
Whatever the degree of monopoly power refiners or retailers have, their ability to pad profit margins is greater in a volatile market plagued with uncertainty.
History and economic theory tell us that crude oil and gasoline markets will settle down eventually, though not necessarily at past lower prices. In the meantime, anger or frustrated resignation will be common emotions at the gas pump.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.