Thought Theater

Gas Prices, Gas Bags, & The Gas Chamber genre: Econ-Recon & Six Degrees of Speculation

No doubt the current energy crunch is a complex equation. A number of factors likely contribute to the rising price of gasoline in the United States. As I understand it, they include the rapidly expanding consumer demand (including China and India), the fact that the U.S. hasn't built a new refinery in three decades and couldn't process more oil even if it were made available, regulation on emissions and an awareness of environmental concerns that have made it more difficult to maintain existing refineries (let alone construct new ones), and the prohibition on exploration in oil rich areas in the interest of preserving pristine national treasures.

While these and other factors contribute to the rising prices at the pump and expand our dependency upon foreign oil, understanding the more obscure factors and motivations may be an equally essential component in achieving a comprehensive awareness of where we're at and what we can do to move closer to energy independence.

I want to focus on the motivations and manipulations that contribute to the crisis. Capitalism is premised upon the willingness of free market participants to exhibit ingenuity in the hopes that it will result in prosperity (profits). Hence the risk reward construct is a fundamental aspect of our economic system. At the same time, supply and demand can impact the price one is able to charge for a product as well as the profit margin one can make on the sale of that product. As such, businesses can be motivated to limit production if it enhances demand and therefore improves profitability. The less competition that exists, the more likely a company is able to manipulate supply and demand without concerns for a loss of market shares.

So how does this apply to the oil industry in the United States? Let me count the ways. First, it is far easier to manipulate supply and demand of a limited resource than the provision of a service. There is no doubt that oil is a limited resource that cannot keep apace with the demand and that means it is a finite product. Those who trade in oil realize that profitability can be manipulated by controlling the supply. Granted, there are provisions that penalize or criminalize some of the manipulations that could take place. At the same time, there are environmental restrictions that afford the cover needed to effect the manipulation of supply.

So how is this achieved? One obvious excuse is OPEC and the willingness of those nations with the lion's share of oil production to keep supply low enough to insure sufficient demand and therefore maximum profit. Since the United States is limited in the action it can take against OPEC, U.S. oil producers can cruise along in OPEC's cash rich wake without reproach.

Another method involves the high costs of exploration and extraction as well as the subsequent cost of refinement. Hence, the oil companies can cite the billions of dollars they sink into finding and removing more oil and it would be very difficult for the government to quantify the levels that would equate with intentional and measurable manipulation. The fact that all of the elements associated with the industry trigger environmental oversight provides additional cover for companies to limit supply.

That brings us to the limited refining capacity. Time and again we hear that the complications and the costs of building and bringing a new refinery on board have been prohibitive...or at the very least...difficult to overcome and a clear disincentive to attempt. Therefore, the expansion of refining capacity has been primarily limited to the expansion of existing facilities.

Oil companies can cite the environmental restrictions, the resistance of communities to allow a refinery in their back yards, and the ever changing environmental requirements that require them to spend huge sums of money updating existing facilities as reasons for failing to expand refining capacities commensurate with demand. Clearly, this provides them with the argument to defend the reduced supply and the rising costs that accompany the growing demand.

Lastly, oil companies can also argue that without the ability to tap into known sources of additional oil as a result of limitations on exploration, it doesn't make economic sense for them to sink billions into refining capacity. They simply have to assert that expanding refining capacity to eclipse exploration potential is a self-defeating endeavor. In so arguing, they hamstring the government's ability to prod them into further refining capacity or to assert malicious manipulation.

Where does this leave us? Well, to a large degree it leaves the consumer between a rock and a hard place. To a lesser degree, it leaves the government with little recourse, under the existing laws, to force oil companies to expand supply. Lastly, it leaves the oil companies in the enviable position of watching OPEC limit supply and therefore elevate the price of oil and the profit that can be made on each barrel. It also enables them to limit their own refining capacities and to contend that it is not only harder and harder to find new sources of oil - they are often off limits.

Looking at the possible motivations and manipulations in chronological context, I think it is reasonable to speculate the following. The oil industry has sought the ability to retrieve huge quantities of oil from protected regions for decades. To date, they have been relatively unsuccessful in achieving that objective. Realizing as much, they elected the fallback position to limit their production capacity, wait until such time as world demand eclipsed supply, rake in the profits that result from the constrained supply in the meantime, and then watch as the American public is squeezed so badly that they will call for the government to ease environmental restrictions and allow oil companies to remove huge quantities of oil from previously restricted areas. I can't prove it but I think it's certainly a plausible explanation.

To a large extent, all of the above requires some level of government complicity. While where we've ended up may not have been strictly the result of informed consent, it is a testament to all that is wrong with naively supporting "free market" capitalism...especially when the players are actually engaged in nothing more than an attempt to corner the market so they can insure that they are free to hose the American consumer without recourse or recompense. Anyone seeking a better understand of the degree to which the political process may have allowed corporate interests to overtake the public's welfare need look no further.

Then again, speaking of naivete, so much for believing that we're moving beyond the use of the "gas chamber" in the United States. I could be wrong, but I'm sure that the subliminal suggestion we're hearing from off in the distance is telling us, "Don't forget folks...the next time you fill up...deep breaths, deep breaths."

Comments

1 On May 19, 2008 at 4:23 PM, Dr X wrote —

Hi Daniel,

I have serious doubts about whether any group or individuals can appreciably influence the long-term prices and profitability of the oil business. If that were so, I would expect that long-term return on investment in oil would be higher than other investments, but as far as I know this is not the case. Instead, like any commodity that is traded, the price of oil fluctuates. Historically there have been booms and busts for investors. If oil companies could really exert any appreciable control over prices they wouldn't experience the severe busts in the cycle and their long-term roi would be higher than other investments on average.

While this is a tough period for consumers (and I am one who feels it), increased prices will push consumers back into higher mileage vehicles and encourage less driving. I have always gone with the high mileage option and we also picked up a pair of used gas-sipping scooters that save significantly. That's not something everyone would be comfortable with, nor would it be practical for many, but in the past few years as I've watched single drivers tooling around the northside of Chicago in behemoth vehicles, I was fairly certain that it would not and could not last. I feel most sorry for the person who is already financially cutting to the bone, the person who depends on a vehicle to make a living and those who can't go the low mileage vehicle route for other compelling reasons, but this is an adjustment we will have to make and I don't think that it is market manipulation that is ultimately behind the circumstance we are in. The market is dynamic, more refining capacity will be built if the crude supply is there and the price remain high. The probelm is that we have hundreds of millions of new drivers hitting the road in Asia -- which is only a problem from our point of view, not theirs.

2 On May 19, 2008 at 5:15 PM, daniel wrote —

Dr. X,

Thanks for sharing your observations. It's always good to hear from you.

I don't believe I stated that U.S. oil companies have the ability to hike prices or profits at will. I stated that they have the motivation to take advantage of opportunities to assist in the manipulations that may achieve either. The fact that they may overplay their hands at times (and suffer bust periods) doesn't negate the fact that they were motivated to take advantage when possible through whatever manipulations they felt were available.

Note that I specifically stated my desire to discuss motivation and manipulation. I then tied that to OPEC since they likely have a far greater hold on the ability to raise prices and dictate profit. The proof is found in the fact that OPEC exists since it would serve little purpose otherwise. Clearly, the alliance is designed to advantage its members. The fact that OPEC just declined the president's request to increase supply...meaning they chose not to...is evidence that they do in fact manipulate supply to their benefit.

The fact that U.S. oil companies can use the actions of OPEC to their advantage is tangible and it speaks to their motivation. Clearly, that motivation is in keeping with capitalism and I've not argued they have committed any criminal acts. What i've argued is that their objectives (motivations) may not match the interests of the citizenry. Again, that isn't illegal...it's simply an observation and a recognition that competing objectives play a part in the supply and demand of oil...and thus the price at any given juncture.

The fact that these companies can explain away their inability to supply more gas as a result of adverse regulatory provisions is the attendant manipulation. Again, the explanations they offer are plausible enough to preclude regulatory repercussions though that has nothing to do with their motivations or their willingness to manipulate the circumstances to their advantage.

I agree with you that consumers will have to adjust...and that they likely will...but there is a time lag that affords those supplying the gas an opportunity to take advantage if they are so motivated and the circumstances allow such manipulations. I'm simply stating that they are so motivated and so inclined to avail themselves of such manipulations.

In truth, most of the responsibility lies with our elected officials in that they have enabled the environment that provides the current opportunities to the oil companies. The fact that we've done little at all since the 70's to address our growing energy dependence seems to be an issue of questionable leadership.

Yes, the public also failed to do its part...but I contend we have government and leadership to persuade or push the public in the right direction. Instead, I'm of the opinion that our leadership also had conflicting motivations that didn't serve the interests of the consumer.

Truth be told, we've known for many years that oil supply couldn't keep apace of demand. The fact that we seemingly ignored that reality is unfortunate. That the actions of our elected officials likely provided a leveraged opportunity to the oil companies is even more disquieting.

Regards,

Daniel

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It seems plausible that large U.S. oil companies may be hoping that higher gas prices will convince Americans to push Congress to allow oil exploration in currently restricted areas. Their actions to allow a supply bottleneck since the last energy cris... [Read More]

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