A Conversation about Gasoline Prices

According to yesterday’s weekly federal report, This Week in Petroleum, the average price of regular gasoline is up to $3.96 per gallon, just 15 cents shy of its July 2008 peak.

A friend writes:

So I’m deciding to ask an economist. It appears to me that the oil companies are really just gouging the American public at the gas pump. Gas prices continue to spiral upward at the same time oil companies’ profits are at record highs. It seems that the media continue to blame higher oil prices because of events in the middle east, but if that were truly the case, wouldn’t profits be lower rather than higher? In it’s last quarter, Exxon’s profits increased 53% over the same period last year. I just never hear of oil companies losing money or decreasing their profit share, so are they really screwing us, or is there a rational, economic explanation?

A few weeks later (sorry bro), I respond:

Good question, but ultimately the economic explantion is better than the conspiracy explanation. I could do a whole dissertation on it and all. But basically speaking…:

1. Suppose the oil companies are doing something fishy to screw over energy consumers. Like a cartel or something (which Adam Smith warns about in Wealth of Nations when he says something like “people of the same trade seldom meet together even for purposes of merriment and diversion but the conversation soon winds up in some conspiracy to raise prices”). They need some way to enforce the cartel, because as soon as it works then each separate company in the industry has the incentive to cheat, and the whole thing easily breaks down. There are fixes, like OPEC that hires auditors and holds regular meetings and there’s no law to keep them from doing it. But generally the conspiracy explanation works only in a small set of circumstances.

2. Markets forces. These are commodities markets. The price we see is the product of traders and speculators. They have a lot at stake, and they take advantage of bits of information they have. The successful ones earn a lot of money, the others try something else. One of the fundamental things about commodities markets, which we all take for granted all the time, is that they act like a magnet for gathering dispersed information about economic value throughout the economy, and they do it in real time. This is what’s going on when prices spike during hurricanes and unrest in the Middle East. This is what happens during the summer driving season. Demand increases, prices increase. Energy retailers are in stiff competition like traders are. That’s why any time a gas station does decide to offer *way* lower prices, it’s usually a publicity stunt and it makes the local news. Companies like Exxon just aren’t in a position to control what goes on among all this, because it’s driven by dispersed information, which no one company or person or government has. When events go their way, I’m sure they’re happy about it, but it’s not like we can give them credit for doing anything more than their jobs to make it happen. Well, that and lobby the hell out of Congress but there’s competition there too.

3. Somehow futures markets and long term contracts mean there’s not a real-time match between a company’s reported profits and its economic health at that time. But I don’t know the details.

4. The general fall in the value of the dollar is one reason why the prices at the pump have gone up.

My friend replies:

Ed, thanks for taking the time to post that. I appreciate the knowledge, though it doesn’t satisfy my desire to hear that the oil companies are collaborating against the public. I still find it incredibly infuriating to [h]ear each year that the oil companies’ profits have increased by 20 or 30% over the previous year.

Stupid dollar.

Amen.