October 20, 2008

Since peaking at a price of around $145 per barrel in July of 2008, the price of crude oil has been falling at a fairly rapid rate. By mid-October 2008 the price of a barrel of crude oil was in a free fall, hitting a a 12 month low of just under $70 a barrel on Thursday October 16, 2008. Just as gasoline prices at the gas pump had risen almost in tandem with the rising price of crude oil during the first 7 months of 2008, they immediately began falling almost in tandem with the price of crude oil as it has dropped by more that 50% of its 2008 high.

This is the way that markets work and is no surprise to those who understand the market process. However, while the economics of falling oil prices are the same as the economics of rising oil prices, the politics of falling oil prices are radically different.

Almost everyone knows that one cannot pump petroleum directly from the ground into their car's gas tank and expect the car to run. In fact crude oil or oil straight from the ground by itself is useless as far as human activity is concerned. Crude oil is basically good for one thing only and that is as a raw material to be refined into a range of useful petroleum products among which is gasoline. However, there is a time lag between the time a barrel of oil is sold on one of the world's oil markets and the delivery of gasoline from that barrel to a local gas station. It takes time to ship the crude oil from the point of purchase to the refinery, the refining itself takes more time, then there is the delivery of the gasoline, via pipeline, from the refinery to local storage facilities where it may sit for a few days or more. Thus, there is a noticeable time lapse between the time the crude oil is sold and the refined product, gasoline, arrives at a retail gas station ready for pumping into consumers' cars.

When oil prices start rising and gasoline prices at the pump quickly follow, elected officials, including ambitious state attorneys general looking to run for higher office, journalists and self-proclaimed consumer activists all cry foul, citing the fact that the gasoline at the gas pump that is being marked up immediately is gas previously purchased by the gas station at the lower prices. Cries of price gouging and accusations that gas station owners are deliberately profiting at the consumer's expense gush out from the mouths of politicians and media pundents. In many cases this rhetoric is simply sensationalism by the press seeking to sell more newspapers or expected class warfare outbursts from left wing politicians seeking media exposure and votes. However, in some states a few gas station owners find themselves hauled into court and fined for breaking obscure anti-profiteering laws.

Ironically, in the current round of falling oil prices, no one is coming forward with charges of price manipulation as gas station owners begin to reduce their pump prices in tandem with falling crude oil prices even though the gasoline being sold at today's lower price is the same gas they purchased a few days or a week or more ago when crude prices were higher. In addition to asking Why the silence? we can also ask Why can't the same profiteers, who supposedly conspired to cheat the consumer by raising prices on gasoline in inventory that they had purchased at a lower price earlier, conspire to keep the price of gasoline high in the face of falling crude oil prices? If there is a conspiracy when prices rise, isn't it logical to assume that a similar conspiracy should exist when prices when crude oil prices are falling?

The fact is that, in today's relatively free and mostly unregulated retail gasoline market, there is no conspiracy behind either rising or falling gasoline prices at the pump. Further, while individual gas station operators do the posting of their current prices, it is the market, not the individual operator which sets the price. While each operator wants to both recover their costs and make as large a profit as possible, if they set their price too high they will lose business and if they set it too low they will sell out fast but lose the extra profit they could have made if they had kept their price at the same level as the market clearing price.

The free market, of course, is an impersonal entity in which prices of products rise or fall depending upon the individual purchasing decisions of the millions of consumers buying in that market. In the final analysis it is you and me and the millions of other consumers who are responsible for the rising or falling prices of gasoline (and all other products). In the immortal words of Walt Kelly's mid-twentieth century classic Pogo comic strip We have met the enemy and he is us.

While costs are an important factor in the profitability or failure of a firm, it is supply and demand in the market, not costs, which determine the current prices of products. While it is true that, in order to make a profit and survive in the long run, a firms revenue must exceed costs, it is unrealistic for producers to expect to break even, let alone make a profit on every transaction. Once a manufacturer produces a product and moves it into inventory or a retailer purchases a product and places it on the shelf, costs become history as consumers' buying decisions (demand) and offerings of other sellers of the same product (supply) become the factors that determine the product's price. With their operating capital tied up in the finished product, manufacturers and retailers are under pressure to sell the product as quickly as possible in order to recoup their investment and move on to the next cycle of production and sales. If a product sells slowly, producers and retailers can choose to either keep the product and lose their entire investment or cut the price and limit their losses - thousands of gallons of high priced, unsold gasoline sitting in the tanks underneath the pumps contribute nothing to the cash needed by a station owner to pay the employees or enrich enrich himself.

So, how do consumers cause the price of gasoline to rise or fall almost in tandem with the fluctuating price of crude oil? After all, aren't most of us dependent upon gasoline to get to work, to stores for groceries and other necessary transportation? The fact is, that as gas prices rise, some people are able to cut back. During each of the recent major run-ups in gasoline prices, sales of bicycles have risen noticeably as certain segments of the population, notably retirees and students, have substituted bicycles for cars for trips to school and stores. The rest of us have also found short term means of reducing our use of gasoline. Among these are car pooling, analyzing each potential car trip and deciding if it is worth making it in terms of the high gas costs, lumping regular individual daily short trips, such as shopping, into a single trip, mapping trips to multiple destinations so as to form a circular rather than zig-zag pattern, etc., all of which tend to reduce fuel consumption. In the spring and early summer of 2008 gasoline consumption in the United States declined by more than 1% as a result of actions such as these by consumers. In fact, an April 28, 2008 posting on the ConsumerReports.Org stated:

Have you noticed that there are fewer cars on the road lately? Recent trends seem to point in that direction. According to the Energy Information Administration (EIA), U.S. gasoline consumption has been declining for at least six months. In the first quarter of 2008 fuel demand was 1.4 percent below last year's levels and it's the third straight quarter of declines according to the American Petroleum Institute.

A decline of 1.4% in gasoline consumption may not sound like much but, according to statistics found on the U.S. Government's Energy Information Administration on October 19, 2008, the United States consumes about 390,000,000 (390 million) gallons of gasoline per day and 1.4% of that works out to almost five and one-half million gallons of gasoline per day (the actual figure is 5,460,000) which is no small sum.

It is obvious that the consumption of gasoline, like that of any other product, responds to market forces by declining when prices increase and increasing when prices decrease. But, why does it respond so quickly to changes in the price of crude oil? Here again, consumers are rational and knowing that their current gasoline purchase will not be consumed on the spot like a meal in a restaurant, will, to the extent they can, try to time their purchases so as to minimize their average gasoline cost. When the price of crude oil begins rising, consumers know from past experience that gasoline prices will soon follow. They will thus try to purchase as much gasoline as possible before the price rise. Since gasoline is difficult and dangerous to store, the only alternative most people have in a market with steadily rising prices is to top off their tanks every day or two. This, of course, leads to an increased flow of customers to the gas pump each day which, in turn, results in a station's gasoline being sold faster which causes it to re-order from its supplier more often and so on up the chain. The end result is a short term increase in demand for gasoline that drives up the price of gasoline at the pump in tandem with the rising price of crude oil despite the fact that the new, higher, priced crude has yet to reach the refineries let alone appear in gasoline sold to gas stations. Leaving the price unchanged would result in ever increasing lines at gas stations and gas stations running out of gasoline and having to temporarily close - which is exactly what happened during the administration of President Jimmy Carter (1977 - 1981) when market forces caused the price of crude oil to rise but U.S. Government policy placed limits on the price that could be charged for gasoline. The result was a classic socialist solution - gasoline was affordable but unavailable.

The opposite happens when crude oil prices are falling. In this case consumers see that prices will be falling soon. Expecting gasoline prices to begin falling as crude oil prices fall, consumers will put off purchasing gasoline for as long as possible so as to capture the lower prices. Now, rather than filling up every day or two, consumers will, whenever possible, wait until their tank nears empty before filling up. Fewer trips to the gas station means fewer sales, so retailers begin lowering prices in order to bring customers back sooner so as to preserve cash flow. Also, station owners, like consumers, know that falling crude oil prices will translate to lower prices when they have to replenish their stocks, which means that they will not be paying as much to replace the gas that they are currently selling at close to or even below cost.

Unlike politics or sporting events (both of which the mainstream media reports in the same manner by choosing to focus on winners, losers and strategy when reporting politics these days) in which there are always winners and losers, the free market is all about free choice. By definition, all market purchase and sales transactions are voluntary. Buyers and sellers only enter into transactions when each feels that they are getting more than they are giving up. I willingly purchase gasoline from a gas station because I know that, among other things, it will allow me to get to work every day and make more money than I am paying for the gas. Similarly, the station owner willingly sells me the gas because the money he receives from buyers like me enable him to pay his bills, replenish his inventory and puts cash in his pocket which he can use to buy food for his family (while some grocery stores now sell gasoline, I don't know of any that will accept a gallon jug of gasoline from a customer in exchange for their groceries). Of course, this doesn't mean that I and millions of other consumers have been happy paying $4 or more per gallon for gas these past few months just as gas station owners are not happy to have to now start lowering their prices below $3 per gallon. However, while the market gives us choices and options it does not guarantee that the choices and options will always be good ones - often the choice is one of choosing the lesser of evils. However, isn't it better to be able to choose between paying $4 per gallon of gasoline or not driving than the alternative in which a distant bureaucrat simply decrees that everyone stop driving?