Gasoline Prices

Brandon Arnold: Thank you everybody, for coming out today. Uh, my name is Brandon Arnold with the Cato Institute. Really pleased to have everybody, have such a big crowd to talk about gasoline prices. Um, before we get started with the actual program though let me just take care of a couple housekeeping notes. First of all I want to make sure that everyone has seen the Cato Handbook for Policy, we distribute this every other year to all Congressional offices. If your office does not currently have a copy of the handbook, please let us know and we'll be sure to get you one. Or if you need extra copies, we'll be happy to get you an extra copy here too. Uh, the Cato Handbook for Policy is pretty much, covers just about every issue that you're going to be dealing with in Congress at least on a basic level. It gives you a libertarian perspective on the environment on social security, on entitlements, pretty much any issue that you're dealing with in Congress, it'll have at least something to say. Its a great starting point as you're discovering new issues, or just looking for a different perspective on some issues you may be working on. Uh, also want to mention the fact that we have a daily email that we publish called Cato Today, we send that out to Hill staffers, let them know about studies that have come out, op eds that the Cato Staff has written. In events like this that happen here on Capitol Hill and back at our office downtown. So I encourage you to sign up for that. There is a sign up sheet outside that you can take a look at. Also, encourage everybody to check out Cato's website which is www.cato.org. If you guys haven't looked at it before or haven't looked at it recently, there is a lot of new stuff there. We just started a blog a month or two ago, which is pretty interesting and we also just started a daily pod, which has been very popular and also events like this are available in streaming media and also in mp3 format, so if you, after this session, you think it was fabulous and want to watch it again, or want to show it off to some of your colleagues, there is your opportunity to do so. With that, I am going to turn things over to Jerry Taylor. Jerry Taylor: Often times when you get into a discussion about anything, someone will stop and say, lets just assume for the sake of argument, x y and z. That's always a fairly reasonable way to begin a big conversation, so lets do that as well. Lets assume, for the sake of this talk, that you and your bosses really care about what the truths are in regards to gasoline prices and energy markets. And lets assume that uh, whatever I say might actually inform some of those opinions and actually inform government policy. I say that because I don't want you to have any illusions that uh, that I am under an illusion, that much of what happens on Capitol Hill is completely unmoored by any factual or intellectual understanding of the issues in play, they are actually reflections of political dynamics where your bosses are forced by constituents to essentially strike a pose to solve problems that may or may not be actual problems, or may or may not be solvable, but politics, nonetheless demands action. So were gonna put all that aside for a second, I understand all those constraints, but lets just assume for the sake of the argument that both you and I are interested in at least one clean shot at the facts surrounding what's going on in energy markets and with gasoline prices in particular. There are two narratives that compete for our embrace on this front. The first narrative maintains the gasoline prices are high because production costs have gone up. You know, the primary input, oil, now sells for $70 a barrel on world crude oil markets, so obviously gasoline prices would be higher today than they were in 1998 when oil was selling at $10 a barrel. And the regulations of increased refining costs, so it costs more to produce gasoline today than it did in the past, and we don't have as much refining capacity on line as we did, say, last year because of Hurricane Katrina. All these things have caused the production costs of gasoline to go up quite a bit and that explains the increase in retail price. Thats narrative number one. Something you've probably heard from industry types and even people like me. Narrative number two. That may all be more or less true, but if soaring production costs were the whole story, than its impossible or very difficult anyway, to explain soaring corporate oil profits if it were simply just a matter of production costs, then oil profits would not necessarily be going up as radically as they are. And moreover, short falls in refining capacity are a consequence of corporate intent. So price gouging plays a significant role here and is a big part of the story that you would not necessarily expect if narrative number one were the primary metric by which you tried to understand these markets. So, which of these narratives is correct? It might surprise you to hear me say that more or less, narrative number two is more correct than narrative number one. After all I work at the Cato Institute, so at least I thought I'd start you out by putting you back on your heels a little bit and telling you something you didn't expect me to tell you. That does not necessarily imply, however, the train of government policies that is often offered as a remedy for the issues identified in narrative two. But first, lets go back a bit and look at both sides of the market, the supply and the demand side of the market, to help explain to you why I am more inclined to take Nancy Pelosi's discussion of oil prices seriously than, say, Denny Hastert's. Uh, first of all, on the supply side of the food chain, there is a clear correlation between the cost of oil and the cost of gasoline. The federal trade commission published a report just last summer in which they had a very nice graph in which they showed regression analyses that tried to look at trends and changes in oil costs and changes in gasoline costs and what do you know, over time the correlation is almost perfect. Its an 85% agreement. So virtually, in all changes in oil prices are reflected in changes in gasoline prices and if you want to know why gasoline prices are moving up or down, more often than not, its entirely due to oil prices. Uh, and with oil prices as high as they are today, of course it stands to reason gasoline prices will be higher. I have no complaint with that argument. Now, why did prices then radically become more expensive this spring? Well, there was a predictable bump in prices because we have a predictable switch over from winter time fuel to summer time fuel and that switch over has been associated with an increase on gasoline prices by anywhere in between a dime and say fifteen cents, depending upon the season. That is utterly predictable as the night following the day. That bump up in price was a bit steeper last spring for a couple of reasons. Reason number one is we still have 450,000 barrels a day of refining capacity offline from Hurricanes Katrina and Rita and so we didn't have as much refining capacity as we usually have to meet the demands for summer time fuel. So that's one reason why weren't able to cough up as much gasoline this spring as we normally would be able to cough up for the market. And the second reason is that the Congress, in its infinite wisdom, decided to mandate the use of 4 billion gallons of ethanol this year. Now in the past, the industry of course used ethanol sometimes by hook and sometimes by crook, but often times by choice, because it was the cheapest way to provide for summer time (unidentified). This year its a little bit different. Uh, the price of ethanol on wholesale markets as of earlier this week of the Chicago board of trade, was at $3.55 for delivery in July. The price for unleaded gasoline for July delivery at the NYMEX was all of $2.10. So what the Congress has wonderfully done is imposed a requirement to use a fuel additive which is actually twice as expensive as the gasoline itself. Now if you talk to people in industry, they will tell you that were it not for this consumption mandate, they wouldn't be touching ethanol with a ten foot pole. They can indeed make summer time fuel blends without ethanol. Normally, its too expensive to do that, they just oxygenate like ethanol or the recently deceased MTBE. But with ethanol prices soaring as they are, they would, that calculation changes. But the mandate is there, they have to use 4 billion gallons of this stuff, so their using it for summer time blends and thats another reason why prices are higher. In fact, according to an article that I saw last week in the Wall Street Journal, industry analysts who were asked to, by the reporter, how much this ethanol mandate was increasing the price of gasoline at the pump, they answered that the result is anywhere between eight cents a gallon and sixty cents a gallon, depending upon who's calculations you took seriously and what market you were looking at. So that has had a very significant impact on the price. Well that's the supply side of the story, thats the sort of thing I'm sure you expected me to tell you as far as why prices are high. But, thats not the only part of the story. Now lets look at the oft-neglected demand side of the market. And this, in my opinion is the real story to explain why gasoline prices are high. Both the global and national economy is doing quite well right now, that's increased per capita incomes that has, in China, in India, in other countries and in American economy is doing reasonably well, that increases demand for transport and that is manifested in gasoline markets and an increase in gasoline demand. This is a world wide phenomena and that means demand is much higher today than it was in the past, so again, the odd thing here is that high gasoline demand and these high gasoline prices are actually a manifestation of good economic boost, robust economic growth. Now, supplies of oil and gasoline have likewise been going up. They are not going down, we are not losing oil. We didn't produce less this year than we did last year, the year before, production of oil is actually at an all time high, but demand is actually surging faster than suppliers can get oil into the market and this is a fairly, and this results in a fairly predictable phenomena, oil and gasoline prices going up because there are more people with dollars willing to bid on these products and the products are not as abundant as consumers demand and thus, the price goes up. What many people don't realize when we look at gasoline markets is that gasoline prices were established in a multitude of large regional spot markets and for those of you who are a little hazy about what a spot market is, think of ebay, ebay is a pretty good example of a spot market, uh, the product is available to anyone who wants to pay the highest price for that product, there is an auction, the highest bider gets the volume in play, thats what spot markets are, they are places where you are buying oil in the here and the now. And what oil company executives do is they tie the price of gasoline that they distribute to their retail franchises or to independent franchises, by spot market prices plus associated business and transportation costs. So even if you, if you watch, say, Bill O'Reilly to get your source of news about markets and how gasoline prices work and whatnot, I would say you're crazy, but if you did that, what you would discover of course, is that Bill O'Reilly, like most Americans, think that prices for gasoline are established by executives in oil companies that sit around back rooms and smoke cigars and figure out how much they can get away with, what kind of plausible excuses they can marshal to justify the prices they want to charge, then they go forth and charge. Its not how it works. The prices are actually established by contracts in this industry and they are tied to these spot market prices. So that means big oil isn't setting prices. Big oil is simply reflecting price, they are price takers not price makers, and this explains why the prices you see at the service stations go up. Now, of course, service stations can do whatever they want, once they got the gasoline. They can charge high, they can charge low, believe it or not, they could charge ten dollars a gallon if they wanted to under normal circumstances and it wouldn't be against any law whatsoever. The reason they don't of course is that competition restrains them and they are not able to charge their hearts content, they actually have to charge vis-a-vis competition, some places that means they can charge more than others because there aren't many service stations to compete with and other places there are more service stations and they have to charge closer to acquisition costs. So that's what really going on in gasoline markets. Is that unfair? Because some people might say look, pricing something based on willingness to pay, or through auction, its all well and good while we're talking about, you know econd hand dressers on ebay, or sports memorabilia or something like that, but it comes to a crucial and vital necessity like energy, like gasoline, its not fair. Well, I guess some people make that argument, nobody that I know makes that argument because most of the economists would consider it ridiculous, whether they're liberals or conservatives and most of us consider pricing by auction as about the fairest thing they could imagine. And we also embrace it as fair even when we are talking about important good. For instance, think of housing markets. You need houses, you need a place to live even more than you need gasoline for your car. But housing markets are established by auction. When you, if you were to go out and look for a house this weekend, you don't look at the price and say, well that's all well and good, but how much did this joker pay for the house eight years ago, you don't care. You don't ask how much it cost to build the house, it doesn't matter. You're asking, what the price is today and whether you want the house more than you want that money. And if you want the money more than the house, you don't buy it if you think the house is more than the guy's asking at least, as far as you're concerned, you'll make the offer for the house. It seems all relatively straightforward. Why don't we scream about price gouging in housing? Because that's all that price gouging really is, is pricing what the market will bear. Its not that oil companies became greedier this year as compared to five years ago or something of the kind, its just the market will bear a higher price today than it could in 1998 when gasoline was selling at nominal terms at about 98 cents a gallon. They can get more so they can charge more, believe me, oil companies wanted to charge five dollars a gallon back in 1990, but there was no plausible way they could do it. The market will bear a higher price and that's what they're charging today. So, if pricing at what the market will bear is somehow objectionable, why don't we put every member of the national association of realtors behind bars? Got me. Its an important commodity after all. But if you look in the business pages, you will find that most economic reporters cheered pricing gouging in housing markets. They fret and worry about a bubble bursting in housing markets. God forbid prices go down, we all cheer that they go up. Why? Why do consumers put up with it. I think the main reason is that they can at least conceive themselves as the price gouger at some point. We're buying houses, we're the victim, but someday, I'm gonna want to sell a house and I'm gonna want to get the market price too and so we're gonna trade places. I'm gonna be, I'll be the gougee today, but I want to be the gouger tomorrow, that seems reasonably fair to everybody so we go along with it. Of course its very hard for people to imagine themselves running a big oil company and so they only see it from one side of the perspective. But of course, its not quite true. There is no guy walking around the streets with the first name of Exxon and the last name of Mobil. If you want to be apart of the oil price gouging game its as simple as buying stock, thats all these companies are, are collections of stockholders, so if you want to be apart of the oil gouging game, you can buy stock and see how you do and make your earnings. Or of course you could start your own oil company. Oil companies, believe it or not, do start up all the time and venture capitalists are there to support them. So I don't find any of this unfair. Free market capitalism is all about pricing. What the market will bear, whether we're talking about Nike tennis shoes or organic bananas or anything else. That's why this economy works very well because it provides signals, very important signals into the market. If the price for something is high, like gasoline is today, its telling consumers this stuff is scarce given demand, which is probably the strongest incentive you have for conservation and its also signaling the suppliers tremendous profit can be made if you can figure out the way to get this stuff into the market. I dare say, it is no exaggeration to claim that leaving the price signals alone in gasoline markets will do more to encourage conservation and new supply that any conceivable set of policies this congress could dream of. So, that having been said, that's my explanation of oil markets. You can't understand price by production costs. Just like any other market, you can't explain price by production costs. Production costs are relevant because no ones, very few people, though it does happen, not too many people want to sell you something for a lower price than what it costs for you to bring it into the market. But beyond that, all bets are off. So, thats my explanation for why prices are where they are. This is the point in the talk where I provide my obligatory thoughts about where oil and gasoline markets are heading, given these realities. We could just stop the conversation here, but usually, what naturally follows what all politicians and staffers and reporters and whatnot and what consumers want to know is, well how long is this gonna last? When are prices gonna come back to normal, if ever? Um, there are two contending arguments here. Uh, one holds that they aren't. That the days of cheap oil are over and there are a lot of smart people who know a lot who believe that. Ben Bernanke said as much in his speech in Chicago just last week. He argued that the era of cheap oil is over and from here through any conceivable future, we're looking at $60 plus, oil. Ben Bernanke is a very smart guy. Before he was at the Federal Reserve, he actually specialized in macroeconomic policy and he mucked around to some degree in energy issues, so he's not a stranger to energy markets either. Um, so Ben Bernanke believes that. Futures traders believe that. Apparently, if you go into the NYMEX to look at what people are buying oil for for delivering in 2012, you will see that they are willing to spend sixty bucks for oil deliveries in 2012. That doesn't necessarily tell you they believe that that will be a good bargain given the market price. They could very well be hedging, so we can't get carried away with statements that futures markets tell us what the best informed actors in the market think the price will be. It may very well be hedging and it might be a different story, but the bottom line is when peoples future markets are looking at acquisition costs down the road, they don't think $60 is a ridiculous figure. So thats, that tells something that might be worth paying attention to. A lot of hedge fund operators believe that high prices will last for the conceivable future. I shouldn't even say conceivable future, forever. And a lot of these hedge fund operators are pretty smart guys and know the old business, like T. Boone Pickens, who is very well known for arguing that cheap oil is gone forever and we'll have to get used to $60 plus oil. In fact, depending upon how giddy he's gotten and how glib he's gotten, he's argues a $150 oil is inevitable in the short amount of time, that sort of thing. Matt Simmons is another fellow who has been in hedge fund markets and the hedge funds business and he wrote a book that's got a lot of attention that's called "Twilight in the Desert", which he argued that Saudi pumps, the Saudi fields are about to run dry and its a big conspiracy, no one wants you to know that its happening, but, and prices will stay high. But Matt Simmons is not just some armchair crank. He's a fellow who's been a consultant in the industry for a long time, he's got his own money at play here, so he has a stake in getting his right and wrong. And of course a large number of geologists believe this. These are fellows who often are enamored with something called Hubbard's Curve and peak oil and I won't go into great detail about that unless you want me to. They believe that uh, most economists underestimate the extent to which existing fields are losing fuel for the market and they are very skeptical that there is much more to find and these geologists have been predicting that the oil was about to run out for a long time now, they've been wrong every time. In fact, just last Thanksgiving, Ken Deffeyes, who is a famous geologist who wrote several books on this subject predicting that we hit a peak in oil production last Thanksgiving. He's wrong. Production is higher than it was last Thanksgiving. That doesn't stop people from calling him up and asking for quotes and giving him a lot of attention. You only have to be right once when it comes to predicting the end of the world, apparently. You could be wrong a lot of times and not too many people will pay attention. Its like Jeane Dixon of the National Enquirer. No one goes back and says, well Jeane, you said UFO's were gonna come down and run the White House and resurrect John F. Kennedy, you know... Nobody comes back to her to ask her about these predictions, but they constantly giver her the front page. That doesn't necessarily mean they're wrong. I mean after all, somebody could be wrong on four occasions and right on the fifth. Um, and there are a lot of ideas. I say a lot of smart people who will believe this. The other alternative is that, we are in a very predictable boom and bust period in the world market. Uh, the argument works like this. If you go back to 1876 or '77 or something in the beginning of the old business and you look at market trends, you'll find a very predictable rhythm to markets. You will find that oil prices go through extreme peaks and valleys at about 25 years apart and that this is the sixth such peak and valley the industry has confronted and its occurring right on schedule. Why does this happen? Is it biorhythms, is it, you know, the phase of the moon, or where planets happen to be, is it kismet? It turns out that its quite predictable when you understand the dynamics of this industry. Elasticity on the supply and demand side is very low. What that means to take the econ jargon out of it for those of you who never took econ, uh, my guess is many of you did not, uh, the reality is, is that consumers respond very slowly to price change. When prices go up dramatically, uh, in a short period of time, I don't immediately sell my SUV and buy a Prius. I don't sell my house out in Laurton to move, Laurton? Fredericksburg to move closer to Washington to cut my commute costs. I don't find out how to get closer to that metro station so I can mass transit. I don't call the slightly annoying neighbor I have to see if he wants to carpool with me, I just pay. So in the short run, a big increase in price does not reduce demand very much. And similarly, on the supply side, changes in consumer demand also don't change product supply very much. So what that means is that the market does not respond very quickly to short term changes then either. That explains why these price increases can take awhile to address. But in the long run, consumers usually act pretty reasonably in the face of high prices. Usually that's as far as the argument goes. And you'll see policy and it'll say, that's why government needs to mandate fuel efficiency standard for refrigerators and cars and all kinds of other things because consumers, for whatever mysterious reason, either for rational reasons, irrational reasons, don't respond to price, government must help them respond to price. Out of their own self interest save the money. Yada, yada, yada... But in the long run there is another part of the story. In the long run, consumers do. Elasticity is 1.0, according to the economics literature, which means that a 10% increase in price will reduce demand by 10%, over the long run. In other words, once consumers believe these prices are here to stay, or at least they are going to be here for a long time, the SUV will go unless its really needed for something, and more fuel efficient cars will come on the road. It means that when you price, when you do your calculations about the new home in Fredericksburg, you think twice because commute costs have just doubled and it may be cheaper to spend more to be closer into where you work. Uh, consumers will use carpools, they will use mass transit. When they have economic incentives to do so. And they always have in the past. This isn't simple hypothesizing and theorizing and perfect world a priori reasoning from libertarians, this is, this is the sort of thing we find through empirical tasks. So what that all means in oil markets is that historically what's happened is prices go up, they stay up for about seven or eight years until a surge of new conservation occurs until a surge of new supply hits the market and it takes awhile for new supply to hit the market the minute Chevron says, I want to develop this field, the time it takes from the decision to develop this field, to the time this field is producing oil, can be seven or eight years. And they're not going to make that decision based on a flighty move in price, because they have to calculate how much profit they're going to get, not given where price is at the moment they decide to drill, but where they think price will be over the entire lifetime of the operation of that facility, what it will average over 20, 30 years, which is wildly different than what prices are today. And so companies are naturally hesitate to invest quickly to bring new supply to the market based on a quick move in price. But over time conservation occurs, new supply occurs, but producers of course aren't coordinating their activities together to say, well we've got a market that's short about X amount of oil, so you produce this amount, I'll produce that amount, we'll meet the demand, everyone will be happy. That'll get you thrown in jail in the United States, but it might make you Secretary General of OPEC. But in the United States, you can't do that. And so what has historically happened time and time again, is that the industry over reacts, they bring more supply into the market than the market can really bear, conservation begins to kick in six, seven years down the road, and then the price collapses. Absolute collapses just as dramatically as it grew. And a classic example of this is a 1986 world crude oil prices dropped all the way down to about ten dollars a barrel virtually overnight. And then what happens in rude crude oil markets, is nobody invests in conservation for awhile, because prices are really low, some of those conservation investments linger on because you don't immediately go and buy the SUV again because you don't know how those prices will last, but eventually the conservation works itself out of the market, nobody is investing in new supply because you now have all this excess capacity and so the market, the industry lives off this excess capacity and after about twenty or so years, that excess capacity has dwindled away, dwindled away, dwindled away until there is very little left. Conservation is no longer a particular concern for consumers and once the excess capacity has whittled away and conservation investments are rung out of the economy, any small change in supply or demand, boom sets the market off and we go through the cycle again. This has happened absolutely predictably in oil markets and occurs about every 25 years. The thing is that very few people are around that remember the last cycle, so every time, if you go back in history, say to 1920 and on and on, every time we've seen this boom and then bust cycle, in every single boom cycle the land was thick with people who said, the era of cheap oil is over, its different this time, we're running out, very smart people say this, the last time this event occurred, which was in the late 1970's, early 1980's it wasn't just Jimmy Carter and crazy liberal democrats and the CIA,