[Editor's Note: This is Part 3 in an ongoing series highlighting the issues surrounding high gas prices and their effect on the industry. In this installment, industry expert Gerald Lewis offers a list of frequently asked questions about gasoline pricing and what can be done about them. To comment on this series or view the previous installments, click here.]
Q: How are oil prices set?
A: Oil is traded on commodities exchanges [image-nocss] throughout the world. The price in news reports is the per-barrel price for units of 1,000 barrels of Light Sweet Crudethe world's most actively traded commodityon The New York Mercantile Exchange (NYMEX). It is the benchmark used for pricing gasoline in the United States.
Q: Is all the world's oil traded through commodities exchanges?
A: No. Much of the gasoline sold by the largest oil companies never goes through an exchange. Many of these companies perform all the functions involved in finding, drilling, lifting, transporting and refining gasoline and pumping it into automobiles. They do trade through exchanges and by other methods and use the benchmark price as the basis for pricing all their sales, whether or not the product went through an exchange.
Q: What makes oil prices rise and fall?
A: There are two factors:
Supply and demand. A trade on an exchange results from matching a willing buyer with a willing seller. In a shortage, sellers can find buyers who are willing to pay more. In a surplus, buyers can find sellers who are willing to take less. Commodities are also sensitive to future expectations. Instability or uncertainty in oil producing areas thus causes prices to escalate beyond what is justified by the reality of the situation. Cost. This is impacted by the actual cost of finding and lifting the oil at the wellhead and by the costs of transporting, refining and delivering it.Q: Which factors are causing the current high prices?
A: Both of them. A huge increase in demand from China and India; a diminishing supply of easy-to-extract oil; failure to conserve in the United States; political instability and conflict situations in Iraq, Iran, Venezuela, Russia, Nigeria and Sudan; shortage of refining capacity in the U.S. exacerbated by complex state and federal environmental regulations; and refineries offline because of Hurricane Katrina, have all turned worldwide supply from a surplus to a shortage in three years.
There is no more cheap oil. New wells are harder and more expensive to discover and extract. Oil refineries are designed for continuous production, whereas environmental regulations, which mandate different blends of gasoline for different states and different times of the year, require batch production, which raises production cost and reduces capacity. Making the different blends requires large capital investments. The rising cost of the fuel itself increases the cost of transporting it. And, because refining had not been very profitable, the refiners increased their prices not only to cover the higher costs, but also to increase their profitability.
Q: What can be done to bring the situation under control?
A: The only satisfactory short-term fix is to be seen as seriously embarking on long-term measures that will first stabilize the situation and then generate new revenues, new industries and new opportunities for leadership. As soon as the expectation is created that the situation is, and will remain, under controland that the shortages are temporarythe price of oil will come down.
These long-term measures include: legislating and encouraging (through incentives) conservation, such as by setting aggressive CAFE (Corporate Average Fuel Economy) standards and raising gasoline taxes to keep prices high; limiting the number of required gasoline formulations; adopting a diplomatic stance to enhance America's influence in dealing with existing and projected oil-supply problem areas, such as impaired production in Iraq, threatened cut-off of supply from Iran, strained relations with Venezuela and radical hostility to the ruling regime in Saudi Arabia; and the development of alternative sustainable and renewable fuels and energy sources, including ethanol, solar, nuclear and wind.
Q: Should oil companies be subjected to a windfall tax?
A: Probably not. If supply and demand are controlled, the market will eliminate the excessive profits that oil companies derive by charging for all product as if it were bought on the open market and by massively increasing their refining margins. Simplifying their product lines will encourage them to invest in new refineries and new exploration.
Q: Recent chain e-mails urge a boycott of ExxonMobil gas stations until the price comes down. Would this work?
A: Most gas stations are operated by small business owners whose margins on gas are in the 10-cent- to 15-cent-per-gallon range regardless of the price at which they sell it. They would be the ones who would get hurt. The big oil companies who supply them would just ride out the boycott and sell the surplus product on the open market at a large profit. Retail competitors not boycotted would reap a temporary windfall.
Q: What does FAQ mean?
A: It stands for frequently asked questions. It may be a misnomer for this piece, because these questions are not asked frequently enough. People seem to be jumping to conclusions about this vital matter without properly understanding it.
Gerald Lewis is a regular CSP columnist and an industry expert. He can be reached by e-mail at glewis@c-man.net or by phone at (646) 215-7741.
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