Mon, 05 Apr 2004

The Price of Gasoline

Everybody has surely noticed that the price of gasoline has risen by about ten cents in the USA. As one commentator put it, "Still sounds like a rip off to me djf". Hopefully I can explain why the free market is acting the way it does.

When prices are stable, you see certain aspects of the station's pricing policy. Martin's Citgo here in Potsdam will take personal credit. Their prices are accordingly much higher, by about twelve cents per gallon. The Stewart's is usually two cents cheaper than the Mobil across the street. They don't let you pay at the pump. They hope that when you come in to the store, you'll purchase enough to make up for the lower cost of the gasoline.

The first effect you see is a rippling of price increases throughout the community. Different gas stations will adjust to the increase at different times. Nobody wants to gratuitiously raise their prices, because that will send their customers elsewhere. Gasoline is a commodity, and retail sales of gasoline are very competitive. Everyone who raises the price of gasoline has a good reason for doing so.

When a gas station buys a tanker of gas, they pay the same price for every gallon of it. Once they've bought it, the cost is immaterial. That price is history. The price they want to charge for that gasoline is the cost of the next tanker of gasoline. That's why prices in a community will rise quickly, even before the next tanker comes. If a gas station has sold most of their gas at the lower price, they'll have to dig deep to pay for the new tanker at the higher price.

Prices will rise on bad news. No gas station wants to sell cheap and buy dear. If they anticipate that the price that they pay will rise in the future, they'll raise their own prices. The worse the news, the higher the increase. The more uncertainty, the more likely any news will be interpreted as bad news. Even rumors will then cause the price to increase.

Prices fall more slowly. First, a company would prefer to make as much money as possible on every tanker they purchase. Second, the only thing forcing the prices down is their desire to sell more gas at a lower price thereby generating more profit. The fall in prices is a process of discovery: how much will you lower your prices by? Nobody wants to lower them too far too fast. That causes a price war, and lowered profits.

Price-setting is always a gamble, a risk, a guess. You have to buy in the past and sell in the future. Anything can happen in the meantime. Everyone who sets prices takes that into account, and adds a little to cover for it. The more uncertainty, the more they have to add. When there's a war in Iraq, when refineries are having trouble, when Venezuelans are up in arms over their national banking policy, when pipelines burst, they add more. Sometimes a lot more.

I haven't said a word yet about demand. The demand for gasoline always rises in August. For whatever reason people take their road trips during August. Probably trying to get in a vacation before school starts, or trying to take advantage of what is usually the warmest weather of the summer. Demand is going to push the price up as well.

Transportation also plays a part in the price of gasoline. Gas is heavy and needs to be transported. If there's a pipeline, that can keep the cost down substantially. The teamsters used to charge $3 to haul a barrel of oil from Pithole, PA to the railhead a century and a half ago. A pipeline could carry it for $1 per barrel. The teamsters didn't like that and sabotaged the pipeline. The pipeline owners hired armed guards to protect it. If a pipeline serving your area breaks, that's going to substantially drive up the cost of gasoline.

Do you think the price of gasoline is too high? You can do your part to lower it by refusing to buy it at those prices. You can (in essence) pay companies to lower their prices by buying gas from companies that lower their prices first. Frequent a website such as Gas Buddy, which keeps real-time local gas prices.

Continued in The Price of Gasoline 2

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