Freeman

ARTICLE

Rising Prices: The Market's Way of Conserving Oil

NOVEMBER 01, 1990 by JORGE AMADOR

Sound familiar? Crude oil prices skyrocket hot on the heels of turmoil in the petroleum-rich regions of the Middle East. Almost instantly, it seems, retailers raise the prices of gasoline at the pump. Consumers begin to grumble.

Enter the politicians, who accuse the oil companies of “gouging” consumers during the crisis. “There is absolutely no reason consumers should already be paying more for oil and gas,” declares one, Senator Joseph Lieberman of Connecticut. “In the last week, American consumers have been tipped off on a massive scale.” Within a fortnight, two dozen state attorneys general are investigating the rise in gas prices, while Congress, though officially in summer recess, manages to hold three hearings on the issue.

Did the politicians lead the attack—or follow safely behind? In a Gallup survey, conducted for Newsweek magazine in the wake of the Iraqi army’s invasion of Kuwait, 94 percent of those polled agreed that “American oil companies were using the Mideast crisis as a pretext” to raise prices. More ominously, 83 percent also believed that gasoline price increases should be limited by law.

Supply and Demand: Not So Simple

New Jersey Governor James Florio aptly summarized the reason why consumers were upset. “The information we have is that there is no problem with regard to supplies,” he said. “Inventories are in surplus, in fact. And yet we see these forces at work with no understandable explanation being offered to consumers.”

Florio’s view is not implausible. Indeed it is true, as far as it goes. The trouble is, it doesn’t go very far. Worldwide stocks of oil were at near-record highs, yes, but the law of supply and demand is more complex than a straightforward accounting of current inventory and consumption. The market rewards those who correctly anticipate the future and prepare for it, and punishes those who do not.

What drove the price of petroleum and, ultimately, of gasoline so high so fast, despite the existing surplus, was simply the concern that armed conflict soon might severely curtail the flow of Middle Eastern oil. As Iraqi tanks rolled into Kuwait, which holds 10 percent of the world’s known oil reserves, and massed on the border with Saudi Arabia, which holds 25 percent, such fears were not unfounded.

“It’s not profiteering, it’s prudence,” one energy analyst told Newsweek. In times of uncertainty, wholesale purchasers of crude oil and refined gasoline try both to buy more and to withhold some of what they have from the market so they can tide over a shortfall should it arise. Consumers engage in a similar practice when, during periods of actual or potential shortage, they try to keep their gas tanks full at all times. “Tank topping” was one of the major causes of the long gas lines of the 1970s.

But why doesn’t competition keep the price down? After all, the oil is still flowing and there are plenty of sellers out there. There are two answers.

One is that competition did in fact soften the blow to consumers. According to petroleum industry analysts, a $1 increase in the price of a 42-gallon barrel of crude oil amounts approximately to a 2.5 cent increase in the price of a gallon of gas. Crude oil prices, which had hovered in the $19- to $22-per-barrel range for most of 1990, fell as low as $15.60 in June and were at $17.30 as late as July 9. They began to rise as OPEC states met that month to discuss Iraq’s demands that strict production quotas be imposed and the price set at $25. Prices remained around $20, however, as Kuwait and others continued to produce above their OPEC quotas, undercutting the $21 compromise cartel fix.

What the dynamics of marketplace competition broke down, Iraqi president Saddam Hussein decided to prop back up by naked force, and so the tanks rolled into Kuwait. The price of crude jumped to $23.11 on August 2, the day of the invasion, and to $28.31 by August 7 as the governments of oil-consuming nations joined an embargo of Iraqi-controlled oil and Iraqi troops approached the Saudi Arabian border.

The $11 surge in the price of a barrel from July 9 to August 7 would normally translate to a retail price increase of some 27 cents per gallon. Yet the average gas price rise in the period was about 21 cents. The national average price of serf-service regular unleaded gasoline actually fell by approximately 7 cents per gallon in mid-July, according to the American Automobile Association. From a 10w of about $1.05 on July 24, it rose to $1.26 on August 9, then moderated to $1.22 by August 13.

An Ounce of Prevention

Another answer is that an entrepreneur who bucked the trend, keeping his prices low and all his supplies for sale in spite of the threat, would run the risk of finding himself out of stock, and out of business, just as the real shortage developed. Some refiners, such as the Sun Company, stopped selling to non-contract buyers in order to ensure the flow of supplies to their regular customers.

“If the difference between our gasoline and our competitors’ is five to 15 cents, we’d have a run on our supply,” said an Atlantic Richfield spokesman to The Wall Street Journal on the weekend of the invasion. Indeed, after going along with the initial price hikes, ARCO froze pump prices for two weeks in an attempt to gamer new customers and fend off the negative publicity that befell most other oil companies. A gallon of ARCO gasoline sold for 13 cents less than the competition’s. It worked for a while, as sales volume increased by 15 percent. But the company suspended the policy August 23 when many of its service stations found themselves out of gasoline to sell.

Selling low to all comers may pay off if the stream of crude never in fact slows down, but it may not be the wisest course while tanks and attack jets are dosing in on the oil fields. The price will remain at the higher level, regardless of actual inventories, so long as the threat of a supply crunch persists.

Rising prices are an early warning signal, the market’s way of encouraging conservation in times of prospective shortage. Should the crisis blow over and the shortage never materialize, prices will fall back as the urge to act prudently recedes. Price controls, which so many Americans seem casually to endorse, wood precipitate precisely the kind of energy crisis that price rises serve to warn us against. They would enable us to indulge our appetite for fuel at the same rate as if nothing out of the ordinary were going on. Meanwhile, as the price of crude continued to soar, wholesalers and retailers would find it increasingly difficult to cover the cost of buying new stocks to sell. Few of us wood enjoy the consequences of price controls if and when an actual shortage came to pass.

Doesn’t this justify raising taxes on fuel, then, in order to encourage conservation? As early as 1980, Presidential candidate John Anderson urged a 50-cent Federal tax on gasoline. Deliberately high gas taxes in Europe, it is said, have helped to shield those economies from oil price shocks.

If taxes have protected against the momentary jolt of skyrocketing fuel prices, it has been at the cost of a constant heavy drain on European economies. Taxes represent well over half the price of gas in Germany, France, and Italy, where in the first quarter of 1990 a gallon sold for $2.74, $3.44, and $4.33, respectively. Even if their governments absorbed the August price hikes by lowering gas taxes, European consumers wood still be paying two and three times as much as we. Had the U.S. followed the same policy, Americans would have spent a decade paying that much more for gas—and that much less on other things we’d prefer-with little appreciable benefit.

For Americans, only when a shortage became a real possibility—ten years later—d the price go up. The market raises prices when conditions warrant it, not before, and as much as is needed, not more so.

Why an Immediate Price Hike?

There is another persistent question. Since oil tankers take several weeks to carry newly pumped crude to the refinery, why did the price of gasoline shoot up right away? After all, the gas at the pump had been extracted, delivered, and refined at the old prices, hadn’t it?

As a matter of fact, much of it had not. As oil analyst Trilby Lundberg explained to The Philadelphia Inquirer, the U.S. “lacks the refinery capacity to meet demand for gasoline during the peak summer driving period . . . . As a result, oil companies have to buy large quantities of gasoline on the spot market and pay the prevailing price.” (On the “spot market,” refiners with excess inventory offer their surpluses for immediate delivery.)

Service station tanks hold only a few days’ worth of gasoline sales; hence on any given day a large proportion of them are getting new deliveries. Because the new gasoline is priced at the current market rate, changes in the wholesale price of gasoline are quickly translated to changes at the pump.

In any event, as we have seen, prudence demands—in light of the prospect of shrinking supplies—that sellers conserve what they do have by withholding it or raising their prices.

The facts may be unpleasant, but the free market does us a service in transmitting them to us so we can prepare for the worst. “Jawboning” the oil companies to limit gas price increases would encourage consumption in the face of impending shortages and render us helpless should the flow actually be cut. At the same time, the market hedges against the threat of shortages to mitigate them when they do arise. Increasing fuel taxes to “protect” us from price shocks would enforce conservation prematurely, hurting us all to avert a transitory trauma. Fortunately, in the free market we have an alternative to the governmental extremes of heedless feast and needless famine.

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November 1990

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