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    Here begins your journey into the mind of everybody's favorite asian, and I don't mean Jet Li.
What follows is the somewhat inane, mostly irrelevant, and self-important ramblings of a man on the brink of madness.
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Wednesday, May 03, 2006
 Supply and Demand Analysis: Gasoline    [L]

The price for just about everything is controlled by a simple concept: Supply and Demand. It's really quite simple - if the Supply diminishes or Demand increases, Price increases. Correspondingly, if Supply increases or Demand decreases, Price decreases. Supply is inversely proportional to Price, Demand is directly proportional to Price.

So when you wonder what to do about the high Price of gasoline, it is beneficial to start with a basic analysis of its Supply and Demand.

Note that I'm not going to get into good/bad arguments in this piece - just analyzing the variables in relation to Supply and Demand.

So sit back and relax - this one's a doozy.
  • Crude Oil - Middle East instability is often cited as the reason crude oil prices are up. Iran's president sneezed the other day and the price of crude went up 2%. While the Middle East might not have any actual physical problems with their oil wells and delivery, the perceived instability and threat of violence is enough excuse for them to raise the price. Crude oil prices affect more than just the price of gasoline - crude oil is also involved in the production of plastics, lubricants, asphalt, synthetics, insecticides, etc. You can bet that the base costs of plastics increase with crude oil.
  • Refinery Output - There have been no new refineries built in the US in the past 30 years. The existing refineries are running pretty much at capacity. We could get have all the crude oil supply in the world and it wouldn't do us any good (in terms of supply) because we are bottlenecked at the refining stage. Thanks to overly strict environmental regulations, and the NIMBY effect, building a new refinery is nearly impossible. The refining problem is compounded by the requirement of...
  • Boutique Blends - Many states, by law, require their own specific blend of gasoline. Further, they may require different blends based on the season. There are at least 40 different blends required for the entire United States. The effect is compound: Production output is decreased, as you can't produce 40 blends as efficiently as a single blend. Production cost is increased, as refineries have to spend extra time and money to do produce specialized blends. Distribution is restricted, because you can't use surplus gasoline from other parts of the nation to shore up dwindling supply in another.
  • Alternative fuel percentage - Congress has also mandated that all gasoline sold must have a certain percentage of Ethanol. Currently, the Ethanol industry is at full production capacity, which isn't enough to meet current Demand. Ethanol availability is another major bottleneck in the Supply chain. I'm not going to get into the discussion as to its benefits/drawbacks - just that it affects Supply negatively.

  • China and India are developing exponentially, and their need for oil is increasing at a pace that far outstrips the Supply. They want oil, and they want it bad. I'd hypothesize that the biggest reason for oil price increases in the past 10 years is due to China and India sucking up as much oil as they can.
  • US oil consumption - that isn't to say we're slacking off either. Despite rising costs for gasoline, we Americans don't seem to be adjusting our driving habits very much. I don't have data for this right now, but I would guess that in the past 10 years, we've increased the miles driven per year, and we've decreased the miles/gallon. But like I said, just a guess.

    Of course, you're going to have that sort of behavior, in a growing economy. The main reason why we've been able to stomach and handle rising gas prices is that we have more money to spend overall (that, and inflation). Obviously, it's not yet economically ruinous, or else you'd see a marked drop in demand. Instead, we use more and more gasoline, the difference is just how much we grumble about it.

The Meddling Government

So, we've covered the basic Free Market forces of Supply and Demand, but let's not forget about the meddlesome hand of the Government.

We can see how they've limited Supply by refusing to drill in ANWR, despite the fact that most Alaskans (those who know the most about ANWR and would be affected most by drilling) support drilling in ANWR, or that the drilling would occupy 2,000 acres of ANWR's 19,000,000 acres (0.01%!). This would increase crude oil supply, reducing the base price of crude oil. Also, the simple action of making another oil source available will serve to reduce the prices on all crude oil imports, as importers will be forced to lower their sale price in order to maintain competitiveness.

The Government has limited Supply by overly-draconian refinery regulations, effectively prohibiting the creation of new refineries, and bottlenecking the production of gasoline.

They have limited Supply by mandating boutique blends, including mandating a percentage of Ethanol in refined gasoline - which the Ethanol industry cannot currently support given the volume of Demand for gasoline.

Now that I think of it, it seems that the Government is best at limiting Supply, thereby increasing prices. I don't see how it could increase Supply, beyond eliminating all the ways they've already limited it.

Government can also indirectly decrease Demand:

Inefficiently, through taxes. They could raise their federal, state, and local taxes high enough that Demand would decrease. However, the taxes required to decrease Demand would far outpace any resultant price drops, and since the goal of this exercise is to figure out how to decrease Demand as to get lower gasoline prices, this is self-defeating.

They could also provide tax incentives for purchasing higher MpG vehicles, decreasing Demand by decreasing consumption. But currently, these tax incentives are so weak that it is still more economical to buy a gas-guzzler, than a hybrid with a tax break.

Another way of reducing Demand is to use alternative fuels. The Government can give grants to research programs developing alternatives. However, this technology, once-developed, will still take at least 10-20 years to migrate to. Even if we found a viable, economic alternative today, it would still take that long to get everything switched over (assuming it's conceptually different from gasoline). And even if we eliminated the need for gasoline, there are still so many other products derived from crude oil that it will be impossible to forego it altogether.

What can be done

I'll start off by telling you what WON'T help:

Price controls - Time and time again, history has shown that Government price-fixing leads to shortages. The explanation is simple. If the price of gasoline is fixed at a low price, consumers will buy more, leading to decreased Supply. Decreased Supply increases the price (somewhere back in the chain, prices will be going up, regardless of price-controls), decreasing the profit gasoline companies make. Somewhere along that timeline, gasoline companies will start LOSING money. You can't force a company to stay in business to lose money, so what will all those gas stations do? They will shut down. If they can't make money (which is the POINT of business), then they will stop business altogether. Then, NOBODY will have gas. For a contemporary case study, check out Hawaii a few years ago.

Ok, you say, but what if the Government just limits the percentage of profit the oil companies can make?

Oil companies currently make 8 cents/gallon - which means that on a $3 gallon, it's about a 2.7% profit margin. Say the Government forces them to limit their profit at a lower price point, what do you think they'll do? They'll stop putting money into gasoline, and put the money into the stock market or any other more profitable venture. Once they stop investing that money into their gasoline business, that will decrease Supply, and, you guessed it, increase gas prices.

History and experience have consistently shown that Government interference with the Free Market does far more harm than good.

So what can we do to lower gas prices?

We can petition our Government to reduce unnecessarily-strict regulations that limit our crude oil supply and refining capacity, increasing Supply. Along the same lines, we can petition them to start building clean nuclear plants, wind farms (watch out Ted Kennedy!), and dams, decreasing Demand.

We can petition our Government to reduce taxes on gasoline. At the Federal level, they take 18.4 cents per gallon as tax, but State and Local taxes vary - New York state has about 60 cents/gallon in taxes (20%). Reducing gasoline taxes would be the easiest way for the Government to lower pump prices.

Of course, the easiest way we can help is decreasing Demand by driving less. It's a bold idea, I know. Hard to believe that the best way to save money on gasoline is to not drive.

Right Wing Nation

Hey Phil,
Good post. I want to ask the question, however, on what product anywhere else is it true that you sell it based on future cost? When it comes to regular supply and demand, and you are a manufacturer, you pay, lets say $10 for the making and shipping and marketing of each of your products. You then mark it up maybe to $20 to make a profit, and the retailer puts his mark up on it. The next batch of product you make, you might pay $13 for the supplys due to the cost of your materials, so you make your product and sell it to the retailer for $23 to keep the profit margin up. There is nothing wrong with that. But if someone says, "The rubber you use will go up next month" doesn't change how you price your item. You still have your 50% markup on how much it cost you to make, not how much it might cost you to make. If the cost goes up in production, you react and increase your price, not vice versa.
If it is the "market" or the gas companies or the tycoons, someone is jacking up the price unnecessarily and if it doesn't really cost more to ship the gas, we still pay the high price and it may go back to normal and we never get our money back for having paid 70% over cost instead of the actual 50% of the norm. Does that make sense the way I said it?
Someone needs to give me my money back for the extra I paid the last few times it went up due to terror threats because nothing bad happened and the oil was never gone or in short supply. GRRRR!

By Anonymous Anonymous, at 5/03/2006 04:29:00 PM      

Hey Phil,
Good post. I want to ask the question, however, on what product anywhere else is it true that you sell it based on future cost?
How about any product out there in the free market? Sellers base their price on what they think consumers will pay for it.

Say I'm tasked to create webpage for a customer. I already have a computer and all necessary applications. I need no perishable materials to produce the webpage (let's exclude electricity cost), so my production cost is $0. Time is an etheral quantity, and can't be discretely quantified with a dollar amount.

Q: How much do I charge?
A: However much I feel the webpage was worth, tempered by how much I think the customer will be willing to pay.

This is the free market. The price of a product is not merely determined by its raw production costs - that merely sets the minimum price (so that the producer can make a profit). The seller tries to maximize his profit, while not charging so much that the customer won't buy.

Reference: water, duct tape, bread, cereal, plywood in Florida every time a hurricane rolls around.

Example: You have 20 gallons of water, and a hurricane is predicted to tear through your area. You paid $1/gallon 1 year ago, during a non-hurricane-threatened time. You need at least 2 gallons to survive the day, 4 gallons if you want to play it safe. That leaves you with 16 gallons left to sell, and another 2 if you take a risk. Your neighbors are not as prepared as you are, and start offering to buy. Assuming your relationship to them is neutral, and you're not moved to charity, how much do you charge? At $1/gallon, the first neighbor will probably take all the surplus water you have, leaving the others with nothing. The neighbors then start a bidding war with each other, each driving the price up higher and higher. Eventually, a maximum price is reached to where the neighbors are either paying whatever they feel the water is worth, or not buying any at all. The side effect of high prices is that consumers will only buy the bare minimum. If they buy less, then there's more available for others. It's a natural way to ration goods based on need.

Maybe it's not a great example, considering that water is a life-necessity, therefore it seems a little cold-hearted. Gasoline, however, is NOT a necessity. It is a luxury.

Your argument boils down to this: "Why do prices change on a product according to Supply and Demand?"

Welcome to the Capitalism.

By Blogger Chu, at 5/03/2006 04:36:00 PM      

so say the government drops taxes on these companies, why wouldn't the companies just leave the price as is and keep the diff as profit (since demand is up and supply is low)

By Anonymous Anonymous, at 5/03/2006 10:11:00 PM      

so say the government drops taxes on these companies, why wouldn't the companies just leave the price as is and keep the diff as profit (since demand is up and supply is low)
Again, the Free Market comes into play.

If the Government drops the taxes, then all of a sudden, there's a lot more headroom for the gas companies to adjust the price. A company may choose to maintain the same price; however, other companies, looking for a competitive advantage, will price theirs lower. The oil companies are not in collusion with each other, fixing the price - multiple investigations over the decades have not found any evidence to support that. So the prices will all drop across the board, as each company tries to sell the most gasoline.

By Blogger Chu, at 5/03/2006 11:11:00 PM      

^^^ speak up ^^^