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What the politicians and the pundits aren’t saying about the fluctuating price of gas and oil- and what you need to know !
There are few things as unsettling as a sharp increase in the price of energy—especially the price of gasoline.
Most of us drive to work, the grocery store, and the day care center. When gas prices shoot up, it hits us where it hurts. Unfortunately, most of us know what those rising prices mean to our budget, but few of us know what is causing those price increases and what can be done about them.
What we all need is a short lesson in energy economics. What is going on, how did we get here, and is there anything we can realistically do about the rising price of oil?
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Oil prices are up. Why?
It wasn’t too long ago—1999 in fact—that the price of a barrel of oil was about $10. These days a barrel of oil can sell for over $70, and some analysts predict that the price could top $100 a barrel in the not-too-distant future. Other analysts are predicting a price plunge, to $40 or less a barrel.
What’s going on? To most of us, this makes no sense at all. Why the rollercoaster?
How can the price of such a vital commodity fluctuate so much in such a short period of time, and is there anything we as consumers (or as a country) can do about it? What forces are at work that can create such a situation, and to what extent are we masters of the situation, and to what extent are we merely spectators and victims?
To answer these questions we need forget most of what is being said by the politicians and the media and relearn a bit of basic economics. Simply put, the current rise in fuel prices is driven by the supply of and demand for oil in the world marketplace, and the political instability of many oil producing countries.
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The price of oil, like any commodity, is set by forces largely outside the control of the major players in the marketplace. Oil producers may be happy that the price of oil has spiked in recent years, but they were just as unhappy about the plunge in oil prices during the 1990s. During those years, supply outstripped demand, and oil producers were forced to sell their products at what seemed to them to be ridiculously low prices. Many, in fact, actually lost money during those years. Today, supply has been outstripped by growing demand, and consumers are in the position of having to pay prices that seem extortionate by normal standards, and profits have risen.
How did this happen? And is there anything we can do about it?
Demand has grown for a simple reason: the world economy is booming, with China and India consuming oil at a much greater rate than at any time in history. Demand for oil in the U.S. has been on the upswing because the economy has been growing steadily and prices (until recently) have been very low relative to historical norms. Supply, on the other hand, has failed to keep up in recent years for a pretty simple reason: those low oil prices of a few years ago meant that it was unprofitable to seek out and exploit new sources of oil. Why look for new sources of oil if there is no money to be made by finding and exploiting it?
As demand soaked up available supply, prices were bound to go up. Now even a small increase in demand can lead to a substantial increase in price, simply because there is less available excess oil on the market.
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Even with the high gasoline prices we are seeing today—often over $3.00 a gallon—inflation adjusted gas prices are still pretty close to their historical average, and much cheaper than they were in the late 70’s and early 80’s.
Other Factors: Government Mismanagement and Bad Luck
Think about where much of the world oil supply comes from: Iran, Iraq, Saudi Arabia, Russia, Venezuela, and Africa. With a few exceptions—the United States,Canada, Britainand Norway—the list of oil producing countries reads like a who’s who of rogue and dangerous States.
In fact, between 80-90% of the world’s oil supplies are controlled by state-run enterprise of one kind or another, and like all government monopolies they are ineficient, mired in corruption, and inclined to do anything to maintain their monopoly power and keep their revenues high whatever the consequences to the world economy.
“Oil prices are rising—not because the world is running out of oil but because the bulk of reserves are in countries where market incentives cannot work fully or in the hands of monopolists who may be exercising their power by restraining investment.”
(Stephen Brown & Richard Alm, Dallas Federal Reserve Bank)
One of the biggest concerns with oil availability is not the quantity of oil available in the world, but who controls it. Iran, Iraq, Saudi Arabia, Venezuela, Nigeria, and the long list of other producers who control world oil supplies are not reliable trading partners, nor are they particularly efficient producers. Iran, for instance, is one of the most oil-rich countries in the world, but their industrial capacity is so degraded by a corrupt political system that they have to import most of the gasoline they consume!
And for those of us who remember the Arab oil embargo of the 1970’s, it is easy to see how international politics can have a direct impact on the availability of oil.
Even here in the United States, the home of capitalism and the free market, lawmakers are constantly intervening in the marketplace in ways that drive up the price and lower the availability of oil to average consumers. For 25 years the Federal government has imposed a moratorium on the exploration for and drilling of oil off the coasts of America, and of course everyone is aware of the never-ending battle over drilling in the Arctic National Wildlife Refuge.
Despite the huge run-up in the price of oil and gasoline, lawmakers have refused to
allow drilling for the billions of barrels of known reserves in U.S. control. It is simply impossible to have our cake and eat it too: if you want oil to be more plentiful and cheaper, then you have to be willing to extract it out of the ground where it is.
With policies like these, is it any wonder that as the years move on, the U.S. gets more
dependent upon foreign oil?
Refining Capacity and the Price of Gas
The price of oil has spiked 700% over the past few years, but the price of gas hasn’t kept pace. That’s because oil is only one of the many factors that determines the price of gasoline at the pump. But the price of gasoline has headed up in recent months for reasons few of us ever think about: the refining capacity of the United States has not kept pace with the demand for refined oil products, and is unlikely to do so in the near future.
The simple fact is that no new oil refinery has been built in the United States in over 30 years, despite huge increases in the demand for gasoline. That means that there is no slack in the market for gasoline: when demand jumps for some reason, prices spike; when the supply is disrupted for any reason, prices spike. Hurricanes Katrina and Rita damaged refineries on the Gulf Coast, and caused immediate spikes in the price of gasoline.
In fact, there is not enough oil refining capacity in the United States to meet the demand for gasoline and other refined oil products. A refinery going out of production for simple maintenance can have a measurable impact on the price and availability of gasoline at the pump. Magnify that effect by throwing in unexpected disruptions such as a hurricane, and it is easy to see how price spikes happen in such situations.
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Few of us think about another factor that makes this problem even worse: state and local regulations have been passed that require special formulations of gasoline in some regions of the country, making it difficult or impossible to shift supply to where the demand exists. Currently there are 17 specially mandated formulations of gasoline—such asMinnesota’s E-10 (10% ethanol mixture)—that make it impossible for gasoline suppliers to cover a gasoline shortage in these regions with product from another area. These “boutique” formulations of gasoline take local areas out of the national gasoline market, and raise prices for consumers.
To further complicate matters, state and federal regulations have begun to mandate the use of Ethanol as an additive in our gasoline. The supply of Ethanol is very tight, and even with massive federal and state subsidies the price of Ethanol has spiked to highs far greater gasoline itself. As of today, there is simply no way that Ethanol producers can meet the mandated demand.
Ethanol formulations also require different tanks and pumping equipment at service stations, leading to substantial costs for fuel suppliers, and often temporary shortages. Right now, consumers are being forced to subsidize the production of Ethanol, and being forced to pay higher prices for gasoline formulated with Ethanol as well.
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Are we running out of oil?
No doubt someday the world’s supply of crude oil will run out, but it seems unlikely that will happen anytime soon. Despite the cries of doom and gloom from some quarters, the world supply of oil is still pretty healthy.
Known oil reserves—oil we know is in the ground that could be recovered—have increased much faster than consumption over the past 50 years. Running out of recoverable oil isn’t likely to be a major problem any time soon.
Of course, that doesn’t mean that ramping up production to meet demand is an easy or instant process. Simply because we know the oil is there to be recovered doesn’t mean we can turn on the spigots overnight. Many factors, such as capital investment, transportation, refining capacity, government regulation, wars and political instability, world oil prices, and you name it all have an impact on how quickly oil can get to market. The oil is in the ground, but that doesn’t mean it can quickly be moved to market.
The lead time for bringing oil to market can be measured in years or even decades sometimes, so don’t expect massive investment today to translate into much lower prices in the near future.
In all likelihood, the industrialized world will shift energy consumption away from oil in the coming years for reasons other than declining availability. High prices, political and environmental concerns including pollution and the possibility of climate change, increasing numbers of options, and government regulations will all change the way we power our economy in the coming years.
Petroleum has been king for a century, and will remain so for years or decades to come. But the end is in sight as technology and attitudes toward oil consumption change.
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What about those high profits?
If you listened to some people, all our woes are due to the greed of the US’s “big oil” companies. Of course, this is silly.
Not because the executives in “big oil” aren’t greedy. It’s just that they are no more or less greedy than anyone else in a market economy. And they certainly weren’t any less greedy in 1999 when the price of oil was under $10 a barrel and the price of gasoline under a dollar a gallon.
Business is business. Farmers are no more or less virtuous than the retailers, and oil and pharmaceutical manufacturers are no more or less virtuous than the local grocer. The functioning of the free market doesn’t depend upon the particular virtues or vices of the participants, but upon a free and fair system that encourages competition between suppliers.
Despite our intuition that oil companies are rolling in dough, according to a recent study by Goldman-Sachs, oil industry returns on investment have lagged behind the rest of the economy over the past 25 years. Oil companies actually make less money than most other industries.
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Take a look at Exxon-Mobil, the most profitable of the oil companies. Over the past year they have generated a net profit margin of 9.7%. That’s good for an oil company but below the average margin of 13.85% for S&P 500 companies and significantly below companies such as Tootsie Roll (15.62%), 3M (15.64%), Coca-Cola (21.52%), Microsoft (31.59%) and U.S. Bank (41.53%).
These low returns have discouraged investment, resulting in today’s high prices. In fact, today’s high profits will spur major new investment in the industry, increasing supplies and eventually lowering prices. That doesn’t make the current price crunch any easier to bear, but a quick glance at how the high prices of the 70’s and 80’s led to the price plunge of the 90’s shows how that process works.
Oil company executives don’t wear the white hats or the black hats in the story of high oil prices. They are simply businessmen in a pretty tough and volatile industry.
Guess who makes the most money on gasoline?
I bet you didn’t know that the single largest oil “profiteer” is government.
In fact, government makes more money from oil than the oil industry.
Taxes make up about 17% of the cost of a gallon of gasoline (depending upon the price any given day). Minnesotans pay 40 cents per gallon in state and federal gas
taxes.
Then there’s the taxes levied on the oil industry. The oil industry has an effective tax burden of 42% compared to the S&P average of 30%.
Add it all together and federal and state governments have collected $2.2 trillion in taxes from the oil industry over the past 25 years – more than triple the $630 billion
in profits made by the oil industry over the same period.
If you want to know who makes “huge profits” off of selling gasoline, look no further than your elected officials.
What about “Windfall Profits” Taxes, “Price Gouging”, and Other Issues Like That?
Politicians aren’t stupid, but it may be a mistake to believe that they have your best interests at heart when they make a policy proposal that sounds good.
Take one of the proposals we have heard a lot about in the last few months: imposing a “windfall profits tax” on oil companies. The idea is to discourage companies from charging too much for gasoline, and to tax away the profits that politicians think are excessive.
Is it really possible to lower prices for gasoline by taxing the profits of oil companies? Can we really believe that higher taxes will lead to lower prices? Obviously, not only does it not make sense, but it would make things much, much worse for consumers in the long run.
How do we know that? Well, we have been down that path before. In 1980, Congress imposed and President Carter signed into law a windfall profits tax on oil, and according to the Congressional Research Service (a nonpartisan research arm of Congress) it cost American consumers big.
According to the CRS, the windfall profits tax caused a 3%-6% reduction in domestic oil production, and increased American dependence on foreign oil by 8%-16%. Overall, the windfall profits tax weakened American oil production and reduced investment in recovering oil out of the ground—not exactly what its proponents promised when they passed the law.
The 1980s Windfall Profits Tax reduced domestic oil
production by 3%-6%, and increased
American dependence on foreign oil by 8%-16%
“Price Gouging” is another complaint you often hear from the politicians and the pundits. The Federal Trade Commission has investigated the oil industry a number of times, and has always found what the economists would tell you to expect: oil prices fluctuate with the market, not according to the whims of oil company executives. The FTC found “no evidence” to suggest that oil companies even had the capacity to, no less the intention to manipulate prices in order to gouge consumers.
FTC’s position [is] that federal gasoline price gouging legislation,
inaddition to being difficult to enforce, could cause more problems for consumers than it solves, and that competitive market forces should be allowed to determine the price of gasoline drivers
pay at the pump. (FTC Report on its “Investigation of
Gasoline Price Manipulation and Post-Katrina
Gasoline Price Increases,” May 2006)
Alternatives to Gasoline and Oil: Myths and Realities
Bad government policies, high taxes, hostile foreign governments, wars, and natural disasters have all conspired to increase the cost of oil and gasoline in recent years, so it’s no surprise that consumers and lawmakers have stepped up the search for alternatives to oil and other fossil fuels.
Unfortunately, much of the discussion about alternative energy sources is ill-informed or misleading, and that doesn’t serve the American public well at all.
Make no mistake: someday, and probably in our lifetimes, new sources of energy will begin to displace oil from its dominant place in the economy. Fossil fuels such as oil and coal have been dominant sources of energy for over a century because they are cheap and abundant, but we have all become familiar with the downsides of depending upon them: oil supplies are concentrated in politically unstable regions, prices fluctuate unexpectedly, and growing environmental concerns have changed our attitudes about depending upon fossil fuels into the indefinite future.
And, inevitably, fossil fuels will begin to dwindle at some point in the future, even if not as quickly as some would have you believe.
But switching away from fossil fuels isn’t as easy as many would have you believe, and the process will take a bit longer than you might expect. And it is very, very expensive.
Our dependence upon oil worries us today because prices have spiked; unfortunately, the alternatives to oil as a fuel source are even more expensive than oil at today’s market prices. In fact, prices would have to increase significantly more before it becomes economically feasible to make large-scale shifts away from an oil-based economy.
Take two of the most often talked about alternatives to using gasoline to power our cars: ethanol and biodiesel (vegetable oil added to diesel fuel). Neither of these fuel sources is a complete substitute for petroleum based fuels, but both of them have been proposed as additives to our current fuels to reduce oil consumption.
In theory, it makes sense. It’s like adding bread crumbs to the meatloaf to increases the size without hurting the taste, adding vegetable oil or ethanol to fuel adds to the volume and it still burns fine and powers your vehicle.
But just as bread crumbs aren’t as nutritionally valuable as meat, these fuel additives aren’t as powerful or as economical as petroleum products. Ethanol is very expensive to produce, has less available energy than gasoline, and gets huge subsidies from the federal and state government. A gallon of ethanol gets a 51 cent subsidy from the Federal Government, a 20 cent a gallon subsidy from the state of Minnesota, is made from corn that is subsidized by the Federal government, and consumers are mandated to buy gasoline with a 10% ethanol content, whether they want it or not.
The result? Ethanol has cost as much as $1 more per gallon on the futures market than gasoline! In fact, Ethanol is in such short supply right now that if you include the federal and state subsidies, it costs twice as much per gallon as unleaded gasoline!
On top of all the subsidies and mandates, there isn’t much ethanol to go around. In fact, if we wanted to produce enough ethanol to replace gasoline, we would need to plant between 51% and 95% of all the land in the United States with high yield corn!
Ethanol has another problem: as federal regulations have changed, more and more ethanol is being used around the country, driving up demand and price at the pump. A gallon of E-85 (an 85% ethanol/15% gasoline mixture) can easily cost $2.50 or more. Add to that the 44 cent federal subsidy, a 23 cent a gallon Minnesota subsidy (plus tax credits), and the cost to Minnesotans for a gallon of E-85 is about $3.17 a gallon. For a fuel that gets about 25% fewer miles per gallon than gasoline.
All this is not to say that biofuels aren’t possible components of our energy future, but right now they aren’t a realistic solution to our immediate problem. They cost too much, require huge hidden subsidies, and yield too little energy.
In the future, we will see better hybrid vehicles, fuel cells, hydrogen, and all manner of new ways to power our economy. But the long history of government mandates and subsidies suggests that it will be private industry and the market that drive those solutions as prices increase and consumers demand options. Top-down solutions haven’t worked in the past, and are unlikely to work in the future. Remember how every house was going to be powered by solar energy? In the 1970’s the government poured huge subsidies into solar energy subsidies, and still today large-scale solar energy is a distant dream.
Right Here, Right Now.
More government mandates aren’t the solution to our oil price woes. As appealing as a “quick fix” may be, what is being proposed today sure sounds a lot like the energy policies of the 70’s and 80’s that gave us solar panels that didn’t work well, gas lines, and a reduction in energy production in the United States.
There may not be a quick fix, but there is a clear path to progress. Here are some basic principles to help guide us as we look at our energy future:
Let the market work!
Doing something always seems better than doing nothing, but history and basic economics tell us that markets are much better at adjusting to short and long-term trends than government planners. Few people know that the gas shortages of the 70’s were caused by government price controls and control over allocation of gas—not by any real shortage in petroleum. The lesson? Markets work better than government planners.
Research and Development Good
Our government has invested billions of dollars in research and development over the years, and the economic returns have been substantial. If we have learned anything over the years, adding to the general store of knowledge yields huge returns. Subsidizing specific businesses and modes of technology may not work, but decades of basic research and development have added considerably to our economic success. Don’t bet on a technology, bet on the value of knowledge.
Subsidies and Mandates Bad!
Science is one thing, economics another. The long history of government interference in the marketplace is filled with cautionary tales: don’t do it. The central planning of socialist economies produced nothing but disasters, and our own history suggests that their experience is the norm, not the exception. Our current focus on subsidizing biofuels and mandating their use is a stumbling block to progress, not a spur. If biofuels are to mature into a viable alternative to petroleum, they will have to be able to compete on an even playing field. The best spur to economic development is the need to compete.
Reduce Government Roadblocks to Energy Production!
No, this doesn’t mean that we should begin strip mining and dirtying up the planet again. The United States is an advanced industrial economy, and Americans have a right to expect that both their environment and their lifestyles will continue to improve, not stagnate or retreat. That means requiring that energy producers not destroy the environment as they produce needed fuels, but that also means that we Americans recognize that the oil has to be recovered and distributed in order to be consumed. Until the world economy transitions from oil to other fuel sources, oil will need to be drilled. As new sources of oil are discovered, they should be drilled. Any other policy means higher prices and more dependence on foreign oil.
High prices lead to greater efficiency.
Nobody likes to waste money. As prices of energy rise, consumers shift their buying patterns. As electricity prices rose, more Americans shifted to more energy efficient lighting. As natural gas prices rose, high efficiency furnaces appeared. As the price of gasoline goes up, consumers will shift their buying patterns from SUVs and big cars to more fuel efficient vehicles. This doesn’t require a government mandate, it’s the way the market works.
Resist Quick Fixes!
Windfall profits taxes, government price controls, mandates and subsidies: they all have one thing in common. They are quick fixes for a long-term trend. Even if they worked in the short-run (they don’t), they would only drive back the day or reckoning and make things worse. |
