Mikeroeconomics: Primer on Gas Prices

Exxon Mobile just released first quarter earnings of $11 billion, the best since 2008. With gas prices in the Muscatine area around $3.73 per gallon, I often hear comments like, “Obama should do something about gas prices,” or “Oil companies should be regulated,” or “The government shouldn’t subsidize oil companies.”

In this editorial I want to explain why gas prices are beyond the control of the government and should not be regulated.

According to Energy Information Administration[1], about 68% of the price of gasoline is oil. About 30% of a gallon of gas is refining, transportation and taxes. This leaves about two cents profit per gallon.[2]

When there are disruptions in the Middle East, the price of oil soars on the fears of higher future prices. Sellers raise the price of gas because replacing current inventories will cost more. Buyers rush to the station to fill up their gas tanks and storage tanks for lawn mowers because they know that the cost will be higher in the future. This combination of sellers removing oil for sale at a higher price and an increase in demand for gas now makes the price climb. Since March, 2010, the price of crude oil has climbed almost 37.3%. During the same time, coffee has increased 81.6% and corn 82.7%.[3] Gold, which commonly reflects inflation fears has risen 27.9%. These commodities reflect future expectations of price increases.

When a good like gasoline is subsidized, more of the good is produced since it is now cheaper for the producer. Ending subsidies on gas and blended Ethanol would mean less fuel and higher prices. Ending subsidies would hurt those people dependent on gasoline to commute to work. Probably, ending subsidies would hurt the low income earners who often work two or three jobs more than those who earn more. Removing subsidies would hurt everyone.

Prices in the United States are set by free market supply and demand. President Obama is not a dictator and doesn’t set the prices. In addition, inflation has contributed some cost-push inflation to the price of a gallon as well as changes to our tax structure.. Adjusting for inflation and comparing a cost of a gallon of gas today to a gallon of gas in 1950, the cost today for a gallon is $3.13.[4]

Some critics will argue that the United States should begin drilling. NAFTA partners Mexico and Canada should be encouraged to begin drilling and exploration. If these partners tap into their vast reserves, critics argue that the supply of oil would increase and the price of gasoline would drop or meet world demand. So why aren’t those countries drilling? My answer is that the price of oil isn’t high enough to act as an incentive for these countries to give up their wilderness and landscape to fill our oil demand. When the price of oil becomes high enough then these countries will find it beneficial to drill. Costs for drilling and refinement of oil are as much as 8 times higher in Canada than in the Middle East.

Drilling domestically would create jobs. In a market where 20million barrels a day[5] are filled, it’s hard to believe that the

United States

could increase the supply of oil enough to lower the price.[6] ExxonMobile perspectives[7], claims the company owns less than 1% of the world’s oil. It is possible that a domestic production of oil might encourage OPEC to cut production and prices would stay in check. This is what economists mean when they say the firm is a price taker. That is, the company can’t influence the price.

Gas prices are a reflection of supply and demand fundamentals, production costs, distribution, and taxes. Gas prices are determined by a number of independent variables unrelated to market manipulation. If gas prices were manipulated, why do they go down too?