Gas prices: get over it already

Sorry it's been so long since my last post - I've been somewhat preoccupied...

Admittedly, I don't like paying close to 3 bucks a gallon for my 87-octane gasoline, but I'm really getting tired of Bill O'Reilly, just about everyone (on both sides of the aisle) in Congress, the underinformed minions on local TV news broadcasts, and anyone else talking about "price gouging", "windfall profit taxes", and whatever other buzzword o' the day that suits their fancy. A simple look at the economics of the situation makes it pretty easy to understand why we're paying more at the pump now. Stick with me.

Worldwide crude oil production is currently about 80 million barrels per day (bpd), after hovering just below 75 million bpd for most of the late 90's. In the meantime, worldwide oil consumption is currently around 81 million bpd, after seeing a slow, steady increase through the same time period. Why? Greater pressures on worldwide governments from environmental interests to limit exploration and new production facilities, and extremely high barriers to entry for new firms (i.e., it's expensive to start up your own new oil company, even if you work out of your garage). Let's think about this: worldwide consumption is greater than worldwide production, and the emergence of China's and India's economies provide no reason to believe consumption is going to slow; extreme global pressures on already industrialized countries to limit their production to facilities already in existence. What's confusing?

The result, of course, is that every little ripple in global production (i.e., Hurricane Katrina, the Indonesian tsunami, OPEC's nose-thumbing at any nation involved in the war on Islamic terror, etc.) causes oil brokers to buy up pretty much any crude they can get their grubby little mitts on, because they know that they're dealing with an inelastic product. For those of you who haven't taken ECON 101 in some years, inelastic means that price changes don't wildly alter buying patterns. Without a viable alternative energy source that people can switch to very easily (if for some reason there was all of a sudden a worldwide spike in ketchup prices, people could switch to salsa, mustard, BBQ sauce, pickle relish, etc. - not so easy to switch your car to propane or vegetable oil). The brokers know that paying a few more bucks a barrel is not going to radically inhibit their ability to re-sell it to the refineries, so paying a premium is not that big a deal. I'll ask again: what's confusing about this?

To put it in perspective, a gallon of gasoline in 1950 cost 27 cents (just google "1950 gas prices"). Inflation in the US has averaged a bit over 4% annually since the same year (google "inflation since 1950"). My financial calculator tells me that a product that cost $0.27, 56 years ago, at 4.2% inflation would cost me $2.70 today (alternatively, plug the 'future value' formula into Excel "=FV(0.042,56,0,0.27)". So the $2.78 I just paid an hour or two ago doesn't really seem that ridiculous, now does it? Add in the emergence of China and India, the oil-industry-specific lack of added production capacity on a product that has proven its survivability, and you've actually got a pretty amazing job by the oil producers of keeping prices affordable.

And finally, a word about "windfall profits". Bullshit - that's the word. Listen up. We've had the ECON lesson, now how's about some accounting?

There are two polar-opposite ways to account for the cost basis for the products you re-sell to your customers out of your inventory (and a handful of combination-type methods that I won't discuss here): LIFO (Last-In, First-Out) and FIFO (First-In, First Out). To illustrate, let's say you sell a widget for $2. Said widget came out of a bin of 20 other identical widgets. You recall that you bought several dozen widgets a year ago for $1 apiece, and you replenished the widget inventory last week by buying 10 widgets for $1.50 each. Under LIFO, you report 50-cent profit on that single widget sale. Under FIFO, you'd figure you made one dollar. LIFO tends to make your income statement more accurate by more accurately depicting your profit margins on goods sold (assuming your most recent cost of goods sold is the most indicative of near-future costs); FIFO tends to make your balance sheet more accurate by more accurately depicting inventory values.

"Big Oil", not surprisingly, being a highly capital-intensive industry, is more interested in having its balance sheet be more reliable, so it tends to use the FIFO method of accounting for inventories and cost of goods sold (or one of the other undiscussed methods that tend to be on the FIFO side of the continuum). The result? When there's a semi-sudden and reasonably sustained rise in oil futures and current crude prices, profits are artificially inflated on the income statement, and the value of crude and refined oil inventories in the firm's possession are accurately increased (is not the value of THEIR crude now higher, too?). As such, a portion of the record profits the oil companies are seeing are an accounting phenomenon; if oil prices fall, those profits magically disappear, using the same reasoning. Now admittedly, not all of the profit is "on paper only" - there are legitimate profits to be sure. But, according to every industry white-paper and government study I've seen (and I've seen about a dozen of them - again, try googling 'oil company profits per gallon') profits on a gallon of gas range between 8 and 13 cents. There's another phenomenon known as 'market timing' that confounds the issue a bit, but it's as easily explained if you think it through.

Let's say you have a business going around with your gasoline can, and you re-fill people's lawn mower tanks. For that service, you charge $5 per gallon - for simplicity, let's say that you recently paid $3 per gallon yourself, you experience $1 in overhead for each gallon you sell, and the other $1 is your profit, which you use to pay your mortgage and your grocery bill. Let's further say that you just finished a day of gasoline deliveries, and knowing that you have a full week of deliveries ahead of you, you re-fill your tanks with $3 per gallon gas before you go home that night. The next morning, on your way to your first delivery, you see that the local stations are now charging $5 per gallon. You still need your $1 profit so you can continue eating in your own dining room, and you'll still experience $1 in overhead for each gallon you deliver. But tomorrow (assuming you bought enough gas last night to supply you all day today), you'll need to charge $7 in order to maintain your cost/profit structure. Should you continue to charge $5? Or do you think one of your customers will know about the $2 spike and buy all the gas you've got for the same price as the stations are charging, (and you'll essentially even deliver it for free!)? Basic economics will tell us that that's exacatly what will happen if the market is even somewhat well-informed (and who among us doesn't pay attention to the price of gas on the station signs these days?). Your best bet if you want to remain a profitable firm is to charge more than $5 per gallon for your delivered gasoline TODAY. After all, you'll have to pay that much just to replenish your inventory for tomorrow.

Market timing is what's causing the roller-coaster we're seeing at the pumps lately. With the volatile geo-political environment, the futures market for crude is very jittery. Because crude oil sale prices are widely reported, all the filling stations know what the market is doing instantaneously, and they can adjust their prices as soon as the market tells it to do so. Hence, even though it takes several weeks for a drop of crude to be pumped out of the ground, piped to the refinery, converted to a usable product, shipped to a distributor, then trucked to the gas station, because of the knowledge of the retail outlets for what their replenishment costs are going to be, a spike in crude prices today almost always means a spike in gasoline prices today, too.

Again, this is not complex stuff, economically. What IS complex is the politics that are behind global oil production. OPEC has obviously got the world by the short-hairs. Competition vis-a-vis OPEC is the only way to keep the cartel from controlling crude prices (via their production levels). Whether that competition be from competing sources of energy or expanded global supply, it matters little, but the choice of which route to take is a difficult matter. If you opt for wind, solar, and biological sources of energy, you're talking about a minimum of 10 years (and that's pretty optimistic) before you'll see a noticeable reduction in the price of crude, given the facts of rising global energy demands and the amount of time necessary to bring those products to market as an economically viable alternative. If you opt for more domestic oil drilling, you're obviously treading on shaky ecological ground.

But I would offer this to opponents of ANWR drilling: our oil supply does not conjure itself out of thin air. We must CHOOSE where we drill for oil. Either we drill in the most environmentally friendly way possible under strict EPA guidelines, and under the watchful eyes of the Sierra Club, Greenpeace, and umpteen other interests, or we continue to buy oil from Hugo Chavez in Venezuela and the House of Saud in Saudi Arabia, where state-seized oil companies operate under the regime's own rules (and the self-interest that is obviously there will influence the operators to skirt expensive environmental protections). Admittedly, Saudi Arabia is not globally known as a bastion of pristine ecological bliss, but the same cannot be said for the clear-cut former rainforests (didn't they used to be called 'jungles'?) that make up a good portion of the oilfields in Venezuela and Brazil. Do you really think that the communist regime headed by Chavez operates in as environmentally-conscious and transparent a manner as any company that would ever drill in ANWR? Just wondering.