Economics 101 - Gasoline Prices

Economics 101 - Gasoline Prices

rev 01.20.2009

This lesson is an introduction to Economics in every-day life.
It's a lesson apparently needed by many people, especially in the United States.

I'm going to use as an example, a subject near and dear to the hearts, minds and wallets of most students: the retail price of gasoline.

In mid-2008, with the price of a barrel of oil around $140USD and a gallon of gas around $3.50-$4.00,
I predicted that the price of gasoline would drop below $2.00 a gallon before the end of the year... (and rise after the end of they year, too...)

[Mouse over the "1Y" label to see how the price of oil changed since then...]

I originally learned this from a friend of mine who owned a small hobby shop back around the First Gas Crisis in the early 1970s. I dropped in to see him one day and noticed that he was marking up the prices on every plastic part or model or toy he had on his shelves. "How can you do that?" I asked... "You bought them at a lower price!"

"Easy," he answered: "All of the plastic models are ... made of plastic, and plastic is made from oil. The price of oil's going up and the plastic toy manufacturers will be paying more for their plastic material, so they're raising their prices to me. I know what my new prices are going to be, and if I don't raise all of my prices today, I won't be able to buy the next shipments to restock my shelves, because they're going to cost me more."

While many people and the media blame "Big Oil" or "speculators" or "greed" for the price of oil or gasoline, there are some reasons why gasoline prices at the retail level change suddenly. These reasons never seem to be mentioned, particularly in the mainstream media [MSM], possibly because the excitement of large-type headlines wailing about the exorbitant price of fuel would disappear if a bright light were focused on the real "drivers" of gas prices. If that were to happen, talking heads and MSM pundits would be lining up for unemployment.

Here's how it really works. [and if you find any faulty logic or reasoning here, please email me as quickly as you can, ok? Thank you!]

Pretend, for a moment, that YOU are a gasoline retailer. You own or lease and run the corner gas station. In the tanks under your pumps is a bunch of gasoline: Regular, Premium, Super-Premium and Diesel.

For simplicity, let's just take one grade: Regular Unleaded. You've got several thousand gallons of it in your underground tank. For the time being, we'll assume that you've been getting regular shipments of it, buying it from your wholesaler/distributor, and selling it for the same price for quite a while. Things are running very smoothly and everyone's getting along just fine.

Suddenly, "something in the gasoline market" changes. Examples we've seen from personal experience include:

A major crude-oil-supplying nation decides to cut production, for whatever reason. The available supply of crude oil drops suddenly, and there's no telling for how long.
A large hurricane or two sweep through the Gulf of Mexico, threatening offshore rigs and onshore refineries. The workers shut down the rigs and refineries and head for higher ground. Production stops for days or weeks. Some rigs are just shut down. Others are damaged and repairs may take years to complete.
An explosion damages a refinery, cutting its output by a large amount. Repairs will take months.
A gasoline pipeline breaks because of a storm or earthquake or some other damage, and goes off-line. It will take days or weeks to repair it.

These are things we've all seen and heard of over the past days, weeks, months and years. Every time it happens, it's reported as a new, major catastrophe by the mainstream media, and the consuming public (yeah, you and me) ... we panic. We rush out to fill our gas tanks as quickly as possible. Right?

So, we've got a new situation: Supply has dropped by a big amount and we may not know how long it will be before the normal deliveries to our station will resume.

What are the sensible ways for you, the retailer, to handle this disruption?

You have only a few choices: you can raise or lower your pump prices or leave them the same. That's all you, as the merchant, can do.

But how can you decide which is the best answer for tomorrow morning, when the news is all over CNN and the morning papers and your customers start pulling in for gas?

Well, you've gotten the news that the supply has been diminished. Fact of life. No way around it. You can also pretty reasonably expect that the local demand will either go up (as everyone tries to fill up the next day) or stay the same, which, is very unlikely.

If you lower your prices, people who might have gone elsewhere will hear of your lower prices and flock to your pumps and drain your tanks dry very quickly.

If you keep prices the same, people afraid of impending shortages due to the drop in supply will still flock to your station and drain you dry.

Only if you raise your prices, (and you might have to raise them considerably) can you try to discourage a surge in demand as people will suddenly want to tank-up, even if they're not short of fuel. The higher price may also cause customers to buy a smaller quantity of gas, so it may last a bit longer than it would otherwise. High prices tend to make people conserve more, right?

But there's another force that will affect the entire gas market, and that's the same supply and demand issue, but isn't limited to just your station.

When the overall crude oil supply drops, for any reason, the overall supply to the whole gasoline market drops with it. With demand not dropping (yet), every gallon of gasoline everywhere is now more valuable because there's less of it being supplied.

The Law of Supply and Demand immediately governs the value of the oil at the wellhead... no matter why the supply was impacted!

If the drillers or refineries can't deliver, any and all oil or refined products anywhere between the refinery and you must go up in price, simply because of constrained production and steady or increasing demand.

Now, you, as the retailer, also know darned well that if the upstream price goes up, your wholesaler will be paying more for every gallon they can buy, so they immediately must raise the price of their fuel on hand or in the pipeline immediately, too. Otherwise they won't be able to buy their next shipment of oil or gas! They don't want to operate at a loss any more than you do. They've got mortgages and kids to put through school too, right?

In order for you to buy your next truckload from your distributor, you're going to need more dollars per gallon than you paid for what's already in your tanks, even though you bought it days or weeks ago at the old, lower price. You have only one choice: raise your prices immediately at the pump level in order to be able to pay for the next shipment you'll have to buy to stay in business. If you're not operating your gas station as a charity or trying to operate at a loss, the answer is very clear: raise your prices immediately.

Now, here's the first rub, and the part that the MSM doesn't tell you, either: How do you know when to lower your prices again, and by how much?

In simple terms, you can't lower your pump price below the cost-plus-profit of the next tanker-load of gas. Only when your supplier's price drops enough can you lower yours.

And that's how it works for virtually everything, although the best, closest-to-the-heart and -pocketbook examples tend to be things like gasoline prices.

That's why retail prices rise quickly in a shortage and drop less quickly. It's how virtually all businesses work.

So next time there's an interruption to the supply of anything you really want or need, fill 'er up if you want, but understand that if everyone does that, it's worse for everyone, and that's why prices have to go up to curb rampant buying [and hoarding] and why prices don't drop as quickly as you or your TV's talking heads would like them to drop.

One footnote... some time back in the '70's, I think it was, some guy on a late-night TV comedy show hinted that there was, for some inexplicable reason, going to be a "toilet paper shortage."

As the rumor spread, people flocked to their drug stores [there weren't any big Club stores back then] and grocery stores and pretty much wiped the shelves clean of TP in a matter of days.

Now, of course, this caused the distributors to do their best to restock the shelves from their inventories, but the demand stayed high and sure enough, the distributors ran out, too, in short order. The stupid joke had, in fact, actually caused a real shortage of bathroom tissue!

And it doesn't stop there... Back at the paper companies, they were merrily rolling along, making bathroom tissue as they always had, and their plants were geared to a pretty stable growth rate as the population grew. They in no way had the excess capacity to refill the TP-Pipeline in any short order. They cranked up production as much as they could, but so long as the "toilet paper shortage" mentality persisted, people kept buying more than they actually needed "because the shelves were still bare"!

Here's the stupid part: if, after everyone had stocked up on bathroom tissue enough to supply their normal needs for a few months, they would have stopped buying it for a while... the "shortage" would have ended and the shelves been refilled as the paper companies refilled the "normal" distribution channels.

All because of one comedian's "joke."

Can we live and learn from this? I hope so. That's why I offer this Lesson in Economics to you all.

Thanks for reading.