I’m not an economist, so maybe someone can point out the flaw in my reasoning:
Competition helps keep prices at a certain equilibrium in a free market, because if one vendor of an item charges a lot over production cost (in order to yield himself greater profit), it’s assumed that some other vendor will charge less (though still enough to make a livable profit) and take away his customers. So far so good, right?
Now, we know that oil companies had record profits in recent years. So why are prices spiraling out of control, equally across all companies? Why is no oil company figuring it can steal more customers from the competition by lowering their prices? They’d be settling for a less profit per unit but make up for that in volume and very likely customer good will.
Nor am I an economist, but I would think that due to OPEC and the like, the price of a barrel is pretty much set. As to the oil companies, well, they’re selling all over the world, which would, again I imagine, allow them to shore up their bottom line.
But what with neither of us being economists, I look forward to being educated.
You have different price models. One is a commodity, where there are many sources for identical products. In this model prices fall to the lowest point, which is no excess profit. If someone tried to raise their price, everyone would buy from another at the cheaper price. If someone lowers their price they will sell out, or drive everyone’s price down. The only way to make more profit in this model is to sell more items.
OTHO you have monopolies, where there is once source. The max profit will happen when you are not selling at full capacity, but when you raise your price so much as to actually lower demand, and you make more profit per item.
Now, similar to monopolies, a few suppliers can get together (illegal in the US however), and form a cartel, which they work together to restrict supply to reap max profits. When a cartel is illegal it may be possible to have a unofficial cartel so to speak, with a wink wink nod nod all sellers raise their price another 10 cents per gallon.
Add to this elastic vs. inelastic markets, which explain how demand will change as prices change, and oil’s demand is pretty inelastic (change in price does not change demand much), we have a big problem if the oil companies switch more towards a monopoly (unofficial cartel).
The flaw in your reasoning is a common mistake made about “free market” capitalism; it presumes people are too stupid to manipulate the system. In this case, I expect that the majority of the oil industry realizes that it’s in their collective best interest to keep prices high for all of them, and a price war isn’t. Not to mention they have a great deal of political influence; it amuses me that Americans put oilmen into power and are surprised that oil prices rise.
< on preview > What kanicbird said about unofficial cartels.
Because there are more than enough customers to go around at the current prices. Oil companies are producing all the oil they can, and selling it without any difficulty. Why would they lower prices? “Stealing customers” is kind of pointless if you can’t produce any more product than you’re already selling.
Oil is one of those commodities that economists call fungible, which means every barrel of light sweet crude is worth as much as every other barrel. If anyone anywhere lowers prices, everyone else has to do likewise, because there is no reason to buy the higher priced stuff.
This is one of the reasons I opppose drilling our Alaskan oil reserves. A major oil find in Alaska won’t just decrease our oil prices, it would decrease everyone’s. Our oil is used, we have the environmental risks, and we only benefit to the extent of our percentage of the world’s oil use. Granted, that’s a high percentage, but it’s not 100%. The oil we have in the ground is like money in the bank, and it only appreciates in value. If we’d drilled for it the first time it was suggested, it would have sold for less than $30 a barrel.
Crude oil costs aren’t the same as the price at the pump. If the refinery system is running near to capacity, then there’s no flexibility to meet supply.
I am an economist, and Gorsnak has it pretty much right. Oil is a commodity, and is traded in an efficient market. The NYMEX is a good example. Why would an oil company cut prices to sell more when the price at which they can sell all their production is known? They are price takers. Imagine you are a farmer growing wheat. You know you can sell your entire harvest for “X” as quoted on the Chicago BOT or what have you. Why would you sell for less than the market bears? You would have nothing to gain by doing so. True, OPEC is a relatively weak cartel that restricts supply, but that matters not to an oil company outside the cartel. They are still price takers none the less.
Competition IS keeping the price down, in the sense that the percentage of the world market held by OPEC nations has decreased to the point where the OPEC cartel has largely lost its ability to control world oil prices.
OPEC hasn’t been restricting production much at all the past couple years anyways. If they wanted to, they could push oil prices much, much higher. In the current marketplace, if OPEC announced it was cutting production by several million barrels/day, crude prices would skyrocket. Hell, the Saudis could do that on their own, without any support from the rest of the cartel. It’s not in OPEC’s interest to trigger a global recession, though.
That makes no sense, if there is no collusion. Every customer that goes to ExxonMobil for gas isn’t going to BP-Amoco (et al) for gas, and vice versa. In a free market, BP-Amoco (et al) should logically be trying to get the customers currently buying from ExxonMobil.
Who says a given company couldn’t produce or procure more if they were getting more customers? I haven’t seen any shortages at the pump. If they’re selling all they can get their hands on, there should be occasional unavailability, shouldn’t there?
Let’s say one of the oil companies decides to sell their oil for %30 less then everyone else.
Everyone shops at that oil company. Unfortunately, they can’t keep up with the demand, and quickly sell as much gas as they can produce. Their stations are often out of gas while waiting for tanker trucks.
However, people still need gas. So they go to the other oil companies and pay whatever their charging.
Net result? The oil company that lowered its prices made less then it would have otherwise.
“illegal in the U.S.” indeed…unless you are a nationally owned oil retailer, preferably with connections to highly placed politicians, in which case you need fear no antitrust action…
Why that should be the case, however, as a matter of jurisprudence (iaal) eludes me…
You’re confusing the issue by conflating the price of crude and the price of gasoline at the pump.
Crude is a commodity, and it trades at whatever rate the commodity exchange determines. An oil company could theoretically sell its oil for less than the exchange price, but there’s absolutely no reason to do so, since they can sell every barrel they produce at the exchange price. That’s what I was talking about, since the OP is ostensibly about the price of crude oil.
The price of gasoline is determined by the wholesale price from the refinery (which is also based on the commodity exchange), plus (I think) the cost of transporting it to the particular gas station. Gas stations mark the gas up at a fairly small margin. From what I understand, they frequently don’t turn a profit on the gas when you take into account the station’s fixed costs (labour, property lease/tax/whatever, building maintenance, etc), relying instead on overpriced soft drinks and snack foods to stay in the black. Gas stations really have very little flexibility in what price they set unless the station owner is willing to lose money on gasoline sales.
So, where does competition for customers come into play? The price of crude and the price of wholesale gasoline are fixed on commodity exchanges, and are affected by global supply and demand (in the case of crude) or regional, often continental, supply and demand (in the case of gasoline). And by the whims of traders, who get skittish when things like political unrest in Venezuela or military conflict in Iraq threatens global oil production levels, or hurricanes threaten to shut down refineries on the Gulf Coast, pushing the exchange prices up due to an expectation of decreased supply, even if ultimately the supply doesn’t actually decrease. This is no different from the price of soy beans or the price of gold or the price of hog bellies. There is competition here, but it isn’t direct competition for customers. There’s no sense in selling below the market price, but as the market price goes up, producers have more incentive to produce, increasing supply and eventually bringing the price down, other things being equal. This happens with oil when oil companies fire up various pumping sites only when crude prices are over $X, because at prices below $X those particular sites aren’t profitable. And, higher prices might make the Saudis decide to open up a few more taps, and in the long term, higher prices provide incentive for oil companies to develop offshore oil, or invest in the capital-intensive process of getting at Alberta’s tar sands, or building a new refinery, etc.
But the only direct competition for customers is between individual gas stations, and as we have seen, gas stations do not dictate what they pay for wholesale gas, and have only a very small markup on the gas. This gives them bugger all room to compete with each other directly on price. Instead, they compete mostly by other means - convenience, service, location, better coffee than the next guy, free coke when you buy more than 30 litres, etc. The only time there’s really any direct price competition between stations is after peaks in the wholesale prices. Take, for example, the period of time following the price spikes after Katrina last summer. Wholesale gasoline prices went through the roof, and gas stations were forced to jack up their prices (and some gambled that consumers would panic and buy at any price, and gouged on top of that). But then it became apparent that there wouldn’t be any largescale shortages, and the wholesale prices settled down. And as they were settling, there’s a lag between the wholesale price dropping, and when the station drops its price. When should the station drop its price (from a profit-maximizing standpoint)? Well, that depends on what the station across the street does. No later than the station across the street, for sure. But the gas in the station’s tanks was purchased at the old, higher wholesale price, so you’d really prefer to keep your price up till you’ve sold this lot. Depending, the station across the street might be in the same boat, so neither of you will move the price down for a few days. Or maybe he’s NOT in the same boat, and drops his price, forcing you to follow suit and eat the loss on the remaining gas in your tank. So there you have direct competition. But that’s about the only place in the whole process.
First off, let me say that I think if you did the calculations, you would find that the main reason gas prices are high is because the price of crude is high and that the additional profit that the oil companies are reaping probably only adds a fairly small amount to the gas price relative to this. I also think that high gas prices are a good thing overall, from the point-of-view of all the externalized costs associated with gasoline use, although clearly it does have a hard effect on people struggling to get by. (I have less than zero sympathy for relatively well-off folks who bought some gas guzzler and are now whining about the price they have to pay to fill their tank!)
Reading over the answers in this thread, though, I don’t really see them as explaining the basic conundrum, which is to my mind: Why are profits for the oil companies disproportionately large when gas prices are high compared to when they are low. I.e., why don’t profits tends to be a fixed percentage of revenues. If anything, one might expect the reverse of what we see, i.e., when gas prices are low, consumers care less about differences in price and the oil companies are able to add a little more onto the price than when prices are high and consumers are very sensitive.
My own guess is that this might actually have to do more with volatility of prices than the price itself. I.e., when the price is not very volatile, consumers can better keep up on current prices and thus are less tolerant of a station charging a higher price. However, when gas prices are very volatile, there is a lack of information in the market…i.e., it would take a lot of effort for consumers to keep up with the going rate now since it is so different than what it was last week. So, in essence, there isn’t as much price competition. But, this is just a hypothesis.
However, I do think that those who are trying to answer the OP should be sure that they are coming up with hypotheses that actually explain the observed data. I.e., generalized lectures about markets and cartels and everything don’t seem to address what I see as the basic question, which is why there seems to be so much more room for oil companies to rake in large profits when the price of crude is high than when it is low.
Record profits it may be, The profit margin that is what to pay attention to.
“Big oil” or lets just pick one Exxon.
Exxon, in 2004 earned more money than any other fortune 500 company, yet at the same time ranked only 127 in gross profit margin. Exxon’s gross profit margin average then was 9.8 cents on the dollar. Way behind places such as Citigroup (15.7), Altria Group the makers of Marlboro (22) and Merck Pharmaceuticals (25.3)
It seems to me that oil company profits go up when oil goes up because they hold large inventories of oil. This of course means that if they drill expensive oil and prices go down, they’ll lose money. Or if they go through long periods of increasingly expensive exploration without getting a reasonable return.
So I think you have to look at their profits in historical terms. What’s the *average profit in the oil industry?
This kind of thing happens all the time in industry. Profits drop as inventories are built, then profits rise as the inventory is sold. What’s important is the average profit.