Behind the high price of gas: so that Americans have access to reliable, affordable gas and oil, American oil companies need to develop domestic sources of supply, but the government won't let them.

Whenever gasoline prices increase significantly in a relatively short period of time and news media report concurrently that the profits of oil companies are also rising, one can predict, almost like clockwork, widespread public outrage. Cries of "obscene profits" will arise, along with demands that the state and federal governments "do something" about the high cost of gasoline. Politicians will fall all over themselves getting to the nearest microphone in order to condemn the "price gouging" being perpetrated by the oil companies on the American public and to threaten the imposition of "windfall profits" taxes. The public becomes convinced that oil companies are engaged in a conspiracy to drive up the price of gasoline.

That's precisely what's been happening recently, and Exxon-Mobil further fanned the flames, when it handed its retiring chief executive a $400 million retirement package. It's hard to understand that kind of compensation, but it's oil company stockholders (more than 40 percent of which are pension funds) who should be outraged over this type of remuneration, not consumers. As hard as it is to believe, hefty executive compensation is not behind the run-up in gasoline prices. Even if the oil executives worked for free, the price of a gallon of gasoline wouldn't be likely to cost even a penny less.

Nevertheless, the profits of the oil companies do appear to be inordinately large, even excessive. But that's because the oil industry itself is so huge. Actually, as a percentage of total sales, the profit margins of oil companies turn out to be in line with the average across all industries, and much lower than a lot of industries, such as banking, pharmaceuticals, and real estate. Of course, that's no consolation to the millions of lower-income Americans, whose very limited discretionary income is being eaten up by rising gasoline prices.

To those who entertain the notion that oil companies alone are driving up gasoline prices, we have to ask some questions: "If oil companies can control gasoline prices to such an extent, then why would prices ever go down?" Also, "Why would oil companies drive up prices, when they know the terrible public relations problems it causes, and the retribution they could bring on themselves by the government?" After all, the last time oil companies made "windfall profits," back in the 1970s, the government imposed price controls and higher taxes (which led to shortages, even higher prices, and long lines at the filling stations). In fact, gasoline prices do fluctuate, and to understand why requires an understanding of the factors that affect supply and demand, and how they interact.

OPEC Crude Cartel

It should come as no surprise to anyone that the price of gasoline is largely dependent on the price of crude oil, since gasoline is produced from crude oil. Once upon a time, America was able to produce, within its borders, all of the crude oil and gasoline it needed. In the 1950s and 1960s, gas stations engaged in so-called "gas wars" that sometimes drove the price of gasoline below 25 cents per gallon. Eventually, however, U.S. crude oil production peaked and started to drop, rising consumption caused demand to exceed supply, and America began importing crude oil in order to meet its energy needs. Today, the United States imports more than 60 percent of the crude oil it consumes. As a result, American oil companies have become price takers, not price makers.

Nowadays, the price maker is the Organization of Petroleum Exporting Countries (OPEC). OPEC accounts for about 40 percent of the world's production of crude oil and holds more than two-thirds of the world's readily obtainable crude oil reserves. Through the setting of production quotas among its member countries, OPEC can influence the price of crude oil, driving it upward or downward almost at will.

This wasn't always so, however, because OPEC once had so much excess production capacity that, when prices were high, some countries cheated on their allotted quotas, resulting in excess production that eventually drove prices down, sometimes dramatically. For example, such overproduction caused crude oil prices to collapse from almost $34 per barrel during December 1985 to less than $10 per barrel during May 1986. Saudi Arabia, whose massive production capacity made it the so-called "swing producer," then lowered its production, restricting supply; and prices moved back upward again. Significant price fluctuations occurred many times over the next two decades, due to continual cheating on OPEC production quotas, remedial action by Saudi Arabia, and geopolitical factors--such as Iraq's invasion of Kuwait in 1990 and the Gulf War that followed in 1991.

A logical question would be: "So, why isn't something like that happening now, especially considering that the price of crude oil has reached a record level above $70 per barrel?" Ordinarily, one might reasonably expect to see the price of crude oil drop considerably from such a level, were it not for the fact that OPEC's excess production capacity has fallen over the years, from millions of barrels per day to around 500,000 barrels per day, according to crude-oil supply analysts. On the supply side of the equation, the insurgency in Iraq has severely restricted crude oil production in that country, anti-government rebels are causing a similar problem in Nigeria, and Indonesia is now importing, not exporting, crude oil.

On the demand side, while consumption of petroleum products in Western Europe and Japan has remained roughly the same over the past three decades, consumption in the United States has doubled. This is primarily owing to America's high use of gas-guzzling sport utility vehicles, pickup trucks, and vans and our economic growth. Consumption in Western Europe and Japan has been kept in check by gasoline prices that are more than double those in the United States and relatively stagnant economies.

China and Inflation

Yet at $3 per gallon, the price of gasoline in America is a relative bargain. Adjusted for inflation and changes in disposable income, Americans were paying the equivalent of $5.17 per gallon in 1955, according to the Cato Institute. In addition, the U.S. commercial trucking industry has experienced extraordinary growth (all of those imported goods from China piling up at West Coast ports have to be transported around the country somehow), greatly increasing the demand for diesel fuel. And then there is the burgeoning size of new residential housing units in America, which increases the demand on energy sources for heating and air-conditioning.

Another big factor on the demand side in recent years has been the rise of China and, to a lesser extent, India. Each has more than a billion inhabitants, together making up fully one-third of the Earth's total population, and their economies have been growing by leaps and bounds. China is now the world's second largest consumer of petroleum products. (Volkswagen already sells more cars in China than it does in Germany.) As reported by Jim Rogers in his book entitled Hot Commodities:

   Oil consumption went from slightly
   more than two million barrels a day
   in 1987 to 5.4 million barrels a day
   by the end of 2003. China's oil imports
   were two million barrels a day
   in 2003, up more than a third from the
   previous year. According to the ... International
   Energy Agency,... China's
   imports are likely to double to four
   million barrels a day by 2010.

As if all of the foregoing were not enough, we would be remiss not to consider the effects of Hurricane Katrina on the production and distribution of gasoline. As summed up by the U.S. Energy Information Administration:

   Hurricane Katrina had a devastating
   impact on U.S. gasoline markets,
   initially taking out more than 25
   percent of U.S. crude oil production
   and 10-15 percent of U.S. refinery
   capacity. On top of that,
   major oil pipelines that
   feed the Midwest and the
   East Coast from the Gulf
   of Mexico area were shut
   down or forced to operate
   at reduced rates for a significant
   period. With such
   a large drop in supply,
   prices spiked dramatically.
   Because two pipelines
   that carry gasoline
   were down initially, some
   stations actually ran out
   of gasoline temporarily.
   However, once the pipelines
   were restored to full
   capacity and some of the
   refineries were restarted,
   retail prices began to fall.
   Increased gasoline imports
   in the fall of 2005, in part
   stemming from the International
   Energy Agency's
   emergency release, also
   added downward pressure to
   gasoline prices. However, retail
   prices are likely to remain elevated
   as long as some refineries
   remain shut down and the U.S.
   gasoline market continues to
   stretch supplies to their limit.

The Iran Factor

At this point, the astute reader may be asking, "Yes, retail prices for gasoline did fall, for a while, but they have gone right back up again over the past few months. What's that about?" Well, every so often, a geopolitical event will have a considerable impact on the price of crude oil--and such an event is now unfolding.

Iran has very bluntly stated that it intends to pursue a uranium enrichment program, while simultaneously calling for the destruction of Israel, That was followed by open speculation that the United States and/or Israel might launch pre-emptive military strikes against Iran. Iran responded by declaring that, should such attacks occur, it would take retaliatory action and close the Strait of Hormuz, thereby blocking the shipping of crude oil out of the entire Persian Gulf area. The uncertainty surrounding the possibility of such events has caused a risk premium, estimated to be as much as $15 per barrel, to be built into the crude-oil futures contracts traded on the New York and London commodity exchanges. *

Since the beginning of 2005, U.S. retail gasoline prices have been generally increasing, with the average price of regular unleaded gasoline rising from $1.78 per gallon on January 3 to as high as $3.07 per gallon on September 5, for all of the aforementioned reasons. Congress, to appease consumer outrage over high prices, made two requests to the Federal Trade Commission (FTC) for investigations into every possible form of price manipulation that could be engaged in by the oil companies. The first request was part of last summer's energy bill and the second request was made in the aftermath of Hurricane Katrina.

On May 22, the FTC released its 222-page study reporting that it had investigated "30,000 pricing complaints," only to find "no instances of illegal market manipulation that led to higher prices" (which should not be surprising, since no federal or state government investigation has ever been able to find broad market manipulation in the oil industry). This was not what Congress wanted to hear. Senate Democratic Leader Harry Reid of Nevada, in what could only be termed political grandstanding, said, "If the FTC report proves anything, it's that federal investigators don't have the tools they need to protect the American people from gas price gouging." In a response typical of populist politicians, senators on both sides of the aisle responded to the lack of price gouging evidence by promising anti-gouging legislation.

As ridiculous as the Senate's resolution sounds, the House of Representatives had already beaten the Senate to the punch during the first week of May. By a vote of 389-34, the House passed a bill to make gasoline "price gouging" a federal felony. Trouble is, the House bill doesn't seem to be able to nail down a definition of "price gouging." Nevertheless, if an oil company is found to be guilty of charging "grossly excessive" prices, it could face a $250 million fine and have its executives thrown into prison. Republican Congressman Joe Barton of Texas, head of the House Energy and Commerce Committee, reassuringly explained, "We know price gouging when we see it."

As the Wall Street Journal observed in its May 11 edition:

   The irony here is that if there is any
   extortion or swindling going on in
   the oil marketplace, Congress is the
   guilty party. It is Congress that ordered
   service stations across America
   to switch last month to ethanol
   additives that have both raised prices
   at the pump and
   exacerbated shortages
   in recent
   weeks. It is Congress
   and state
   governments that
   take 59 cents a
   gallon on average
   of fuel taxes at the
   pump--almost six times the average
   of l0 cents per gallon profit that
   the oil companies make.

So, even if all of the oil industry profits were taxed away, a $3.00 gallon of gasoline would only drop to $2.90. Big deal? Obviously, relief is only going to come by increasing domestic supply, but Congress continues to reject any attempts to allow oil drilling in the country's coastal waters, on federal land in western states, or in Alaska, where tens of billions of barrels lie waiting to be put to productive use. Instead, Congress prefers to pursue an energy policy that transfers America's wealth to countries such as Iran, Saudi Arabia, and Venezuela. In the final analysis, it's not Big Oil that's driving up the cost of crude oil and gasoline, it's Big Government.

* At 42 gallons/barrel, this risk premium works out to about 35C/gallon of gasoline.