Tuesday, April 22, 2008

Why I'm hoping for $6.00/gallon gasoline

Gas prices are high. And while we don't typically see drivers rending their shirts and screaming up at heaven, cursing prices at the pump, most of us recognize it costs us almost twice as much to fill up our automobile now than three years earlier. So what's the deal? Is this outrageous price gouging? Are we running out of oil? Do we need government intervention? Again, answers are (in no particular order), no, no, and no. Let me attempt a meager explanation to the crude oil conundrum.

As you probably guessed, there are a few factors at play. But the underlying theme is that we are experiencing very basic economic theories here. What follows is an amalgamation of personal research along with some salient points as explained to me by an energy executive I met with upon contemplation of an investment.

What's behind the price?

Demand has a little something to do with it, I'll explain that in a minute. But approximately 30% of gas prices are determined by taxes and inflation. So, in an environment where both taxes and inflation are increasing, we would expect the price of oil to increase as well. According to the representatives I met, adjusted for inflation and taxes only, the price of a gallon of gas should be approximately $3.13/gallon. But prices are higher than that (based on national averages) and there is clearly more to the picture than inflation and taxes. It's the cost of crude oil, refining capabilities, and demand. Refineries are having a hard time keeping up since the energy infrastructure we are dealing with is thirty years old and was built to accommodate a somewhat lower demand. Producers also deal with increasing environmental compliance. Some crude is also more difficult to reach. Obviously, the easier it is to get from the ground, the cheaper it is. For example, because of the location (in the ground/ocean) of the crude oil in the middle east, it only costs about 15$ to extract a barrel, while in the gulf coast it could cost up to 65$ a barrel. Factors such as the depth and quality of the crude will determine the cost to pump and refine. But a common mistake is to think that the costs of production are solely responsible for the rising prices at the pump. The first step is to realize that inflation and taxes play a critical role. Now, is there price gouging on top of that? Nope.

Bottom-line, we don't have a choice. Or do we?

Price in-elasticity. That's what is at work here. In simple terms, if something is said to be price inelastic, it means that the change in demand will be minimal relative to price changes. If something in price elastic, then demand will change more drastically relative to price. What determines whether something is elastic or inelastic? Substitutes. For example, if you're going to the store to buy Ketchup you will notice there are roughly a dozen brands to choose from. And, for most of us, the Ketchup tastes the same. If Heinze decides to increase the price of their ketchup, most rational shoppers will simply choose another brand, maybe the generic label, because it is cheaper. In this example, Ketchup is price elastic, rather, the demand for their ketchup is very sensitive to price fluctuations due to the prevalence of substitutes. In contrast, let's take, um, gas as an example. If gas prices increase, where can we go for alternative fuel in the short term? Nowhere. There are no substitutes in the short term. If gas prices increase 20 cents between today and tomorrow, I can't go out and buy an alternative fuel. Then why don't gas stations simply jack the price way up? Because they also have to worry about the long run. Although I can't do anything about a gas substitute right now, I can over the course of a year or two. I can figure out how to take the bus, ride my bike, or buy an alternatively powered automobile. But for now, I'm stuck.

What about our shrinking oil supply?

Now that we understand a little about demand, let's briefly talk about supply. Is there a problem? Yes, but probably not the one you are thinking. Most pundits report we are "running out of oil!" or "We only have 30 years of oil supply left!" Well, this is technically, but not actually, true. Going back to the costs of production, it makes sense to drill where you know oil already is. Looking for more oil costs money. And you can rightfully assume that oil has been discovered long before drilling takes place. So even though the supply we are working with now is certainly finite, that does not mean we are talking about all the crude oil on the face of the earth. If I carried the pundits mentality of a shrinking oil supply to my own life it would be like me walking into my kitchen, examining all the food I have available, and then exclaiming "Holy crap! I only have 14 days of food left!" See the problem? I am going to buy more food and oil companies will drill in new reserves once the current lot is substantially depleted.

Now the truth to the supply argument comes from the uncertainty of demand. Oil companies try and forecast the demand years out in order to determine what they need to pump today (it takes roughly eight years to get oil from ground up). What they totally missed fifteen years ago was the demand for oil in China and India today. Whereas five years ago the industry could say "based on our current supply, we have 45 years of oil in reserves," today they are saying "if this current consumption keeps up, we only have 30 years of oil." But remember, we are only using developed oil fields. There's plenty more untapped elsewhere. So the majority of the huge spike has to do with anticipation of future demand (i.e. China and India in ten years).

The final problem comes from the control of the supply. Yes, it would make things a lot easier if we stopped threatening to nuke Iran. And you can be sure a major reason we are still in Iraq is oil. And Hugo Chavez (in Venezuela) hates our guts. By the way, what do I think of Hugo Chaves? Most experts agree he is a very astute populist politician. Here, I differ from the experts, I just think he's exceedingly stupid. In fact, he's an idiot! I don't know how you run a national deficit with the kind of oil money he's bringing in. Wait, yes I do. That leads me to my next point.

Government Intervention

Hugo Chavez, because he runs a socialist regime, has implemented price ceilings on many goods and services in order to make goods more cost effective for his constituents. What's wrong with that? Again, incentives. If I'm a corn producer why would I sell my goods to Venezuela, or any other state/country, if there is a ceiling on the price? I'm simply going to sell to whomever can give me the higher price (which may be another country). There goes your supply and you've increased demand by keeping prices artificially low. Consequently, you see long lines, shortages, and riots. While Hugo is waiving the Venezuelan flag, farmers are giving him the finger.

This is why price ceilings are not the answer to gas prices in the U.S. The free market needs to be able to do its job. What about in emergencies, like hurricanes? Again, the market should be allowed to do its job. In the Gulf states, during hurricane Katrina, many gas stations, for fear of impending lawsuits from price gouging, refused to raise prices even though there was huge demand. The result? Thousands of motorists stranded on the highway in the path of the hurricane. Recognize the ripple effect if the opposite happened. What if the gas station owner increased prices to $50/gallon or even $1,000/ gallon? "That's just price gouging," you say? How can an owner be accused of gouging if he can justify that his price meets the demand? That's rational economics. But, hear me out. Say the price, overnight moves to $200/gallon at news that a hurrican will hit land in two days. Then many would simply not be able to afford to fill up and leave town. Then they are incentivized to take extra precautions at home, or go to a fascility (like a stadium, school, etc.) or find any other alternative solution, which would decrease interstate traffic. But more important would be the long term impact if every consumer expected prices at the pump to climb due to emergencies. In short, consumers would come up with alternative plans, or any plan, and that would be a step in the right direction.

Look on the brighter side

The recent ascent of oil prices is finally making an economic case for alternatives. Before, it wasn't cost effective to produce alternative fuels, without governement subsidies. Now, we have an economic incentive to produce cars and other equipment that run on alternative fuels because they are becoming a more viable substitue for oil. For those "green" fans out there, the worst thing that can happen is for oil to fall back down to $50 a barrel. I say keep going up. I'm already reviewing how I'm going to adjust. Does this mean Ethanol will take off? No. Why? Because we eat corn. Anytime you try and create energy from part of the food chain someone is going to complain, probably, those that don't have food (as an aside, it's hard to make a compelling case for turning corn into fuel when there are massive food shortages in parts of the world. Maybe this shortage is the last straw we need to convince government that corn subsidies are a bad idea). No, corn-ethanol is not the answer.

Instead of imposing price controls, the government should make it easier for companies to refine oil (i.e. by lessening regulatory requirements, excise taxes on crude, and drilling requirements). That is, unless their constituents are asking for alternative solutions. In my estimation, this is the real issue. Cheaper gas prices create an economic argument against alternative fuels.

An incentive for innovation, that's what $5 or $6/gallon gas prices will do.


Nate said...

And this is why I will be buying a Prius or taking the bus to work.

KVB said...

I suppose as long as we can afford our current wasteful lifestyle there is no incentive to change.

Jenga said...

"As long as we can afford," that's the key phrase. Another $2 bucks/gallon and we will hear serious screaming from the middle-class. Experts (meaning those on Wall Street that think they are experts) seem to believe tax-cuts for the middle class are inevitable.

Jessica said...

A prius is a good idea. So is taking the bus.
I just checked for Mark's route to work. It would cost him $5.50 a day and take 2.5 hours (each way). Yikes!
Maybe carpooling is a better option.

KVB said...

The bus to school here is a pretty good deal, especially because it is included in tuition, and no one can get out of it anyway.

Jessica said...

Ok, so you haven't mentioned microcredit in this post, but if you could do another post on it, and address this article, saying that it makes poor people poorer, that would be nice.

Nate said...


I don't think that's a complete link. Double check it for those curious.

Jessica said...


mom said...

I'm buying new walking shoes -- which are roughly the cost of our first car...

Jenga said...

HA! Nice logic.