Jun 26, 2008
Efficiency, Energy

How to lower gas prices: Calm down, and learn some economics.

The current state of record gas prices has lead to a barrage of uninformed discussion and downright silly claims that is absolutely maddening. Why more economists don’t step in to correct the record and straighten out the nonsense (mostly in the name of maintaining “neutrality”) is also frustrating. Last time I checked neutrality has nothing to do with differentiating nonsense from fact.

Claims are made that the oil companies are “price gouging” and as a result oil company executives are dragged before Congress, forced to explain basic economics to the politicians too inept to have studied it to begin with. I’m sure you’ve heard by now the claim that Exxon Mobil made “record” profits in 2007, a whopping sum of $40 billion. Lots of financially-dull people quote this figure even though it’s utterly meaningless outside the context of revenue (except to point out that these companies are indeed large), which is a little more revealing: Exxon Mobil’s profit margin (profits as a percentage of revenue) were 10.9%. If you’re under 35 your mutual fund probably averages more than this. Since Exxon Mobil is such an evil company that’s profiting enormously from the American consumer’s pain at the pump, it surely must be the most profitable large company right? Of the Fortune 500 companies (which yes.. actually includes 500 companies), 138 had higher profit margins than Exxon Mobil. The other two major oil giants, Chevron and Conoco Phillips, had profit margins around 7%. Hardly sounds like windfall profits to me, and this even in a time of of a heightened oil futures market, where one would expect oil company profits to be larger than normal. In fact, many other industries have significantly higher profit margins, but you never see anyone complaining about them. So next time your family member mentions the $40 billion figure, ask them to guess what the profit margin was (if they understand what that means) and you’ll likely get absurd answers like “60%”. Then serve them a healthy dose of reality.

The next target for the villain-seekers is the evil “speculators” on the oil futures market that “artificially” push up oil prices and need to be “controlled”. Explaining how the oil futures market work to every day gas price complainers is an exercise in futility, but the economic theory on this is rather clear: futures markets efficiently allocate risk in commodity prices to those best able to study and analyze the market. The effect on prices over the long term is a smoothing-out effect of what would otherwise be a more volatile market. As we know from finance, risk/volatility inherently must carry a risk premium relative to less risky assets deriving from the principle of risk aversion. So with lower risk comes lower prices in the long run. However, this also means that at time of high-price speculation, the price of oil is probably higher than what it would be without speculation. This is the fact many complain about, however the other side of the coin is that at a time of low-price speculation, the price of oil is probably lower than what it would be without speculation. Over the long run, however, prices, theoretically speaking, are lower. So not only are commodity futures markets not harmful, they are efficient and helpful to the economy as a whole.

Interestingly this same concept of volatility was brought to my mind as soon as I read the absurd description of a Facebook group a few months ago saying we can lower gas prices by choosing one day to NOT buy gas. The non-reasoning implicit in the idea aside, one would actually expect this tactic to increase gas prices as a result of increased demand volatility as well as less ability to maintain an efficient, smooth daily supply of gasoline to stations.

Another area of volatility for companies in America is regulation and litigation, which in some cases is a huge risk to the operation of a business. If the American government has almost unlimited power to slap regulations on a company’s core product, risk of revenue production increases which, all else held equal, makes that company less valuable. This certainly applies to oil companies as well and when politicians pander to voters’ serious lack of economic understanding by “punishing” the oil companies with “windfall profits taxes” and other such gimmicks, this makes doing business and revenue production more risky for these companies. The point here is that we don’t need the regulation to actually take place for it to harm the ability of oil companies to supply oil (yes, this does drive up prices… oil is a highly competitive market with little ability for individual companies to “control” prices, despite popular myths). I can assure you the oil futures traders (and all financial traders… in stocks, commodities, otherwise) pay close attention to potential regulation that would affect the market in which they operate. The mere talk of regulating oil companies could cause price changes. The mere talk of regulating industries like tobacco and other “hated” industries reduces the market value of their companies.

As such, you can do your small part to reduce gas prices by stop bitching about the oil companies and the speculators and stop allowing politicians implementing borderline insane policies to pander for your vote. Make regulation risk for oil companies as low as possible and let them do what they do best in a competitive market - supply energy :).

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