Wednesday, September 20, 2006

Utah's High Gas Prices Respond to What We Do

This Deseret News article explains that some Utah gasoline retailers have at least one explanation for why gas prices in Utah are failing to fall along the lines of gas prices nationwide, making Utah one of the most costly places in the nation to purchase gas. Are you ready for this? Here it is. “[P]rices haven't fallen because stations are still using up gasoline purchased weeks ago at higher prices.”

Let me put it bluntly. This is bunk.

I once worked for a company in the petroleum industry that had operations that included almost every phase from exploration and extraction to refining to retail. The price they charge at the pump is only very loosely tied to the actual price paid for the product being delivered at any given moment. Rather, it is more closely tied to replacement cost of that product.

Let’s try a little thought experiment. You need gas, but you’re late for work. You figure that you’ve got enough to get you there and back, so you plan to fill up on your way home. You look at the gas retailer marquees on your way to work and notice that gas is about $2.10 per gallon. During the day news comes that a nasty hurricane is ripping through part of the Gulf Coast region, possibly shutting down a number of oil refineries. In the afternoon you leave work and notice that gas retailers are now charging $2.85 per gallon.

This is no fairy tale. It’s the actual scenario that we experienced just a year ago as Hurricane Katrina was doing her worst. What happened while you were at work? Did the product purchased weeks earlier by the retailers suddenly retroactively shoot up 36% in cost? Of course not. Instead, retailers were now basing prices on what they believed it would cost to replace their inventory given reduced availability.

If retailers now argue that they won’t drop their prices because the inventory on hand costs more than the replacement cost of that inventory, they are either (take your choice): a) lying, b) stupid, c) greedy, d) some combination of a, b, and c.

Look folks, you can’t have it both ways. If you’re arguing that prices are based on original cost, why doesn’t it work that way when costs increase? What we really have here are petroleum industry representatives that either think we’re stupid enough to believe this tripe or are stupid enough to believe it themselves. That’s unlikely.

Let’s get down to what is really going on. Retail gasoline prices work like you learned back in Econ 101. Oh, there are a few twists and turns on the old supply-demand curves, but it’s not radically different from the basic model. Retailers continually attempt to set the price to maximize their profits. It’s a continual balancing act that attempts to find the highest price at which demand does not decrease. Of course, it’s based on inventory costs (mostly inventory replacement costs) as well as operational costs, but the margin is established by what the market will bear.

What this means is that while Utahns whine about high gas prices, they continue to fill up at a pretty brisk rate and to shell out the price at the pump. The high cost is not causing us to cut back on driving. In essence, it doesn’t matter one bit what we say; it only matters what we do. There are a whole variety of factors that go into the base cost of the retailers’ inventory, but the moment demand falls, gas prices will fall to try to hit that magic point at which the highest margin can be maintained without reducing demand.

So, if you don’t like the high gasoline prices, you’ve got to demonstrate it by your behavior. Of course, this only works if lots of your neighbors follow suit. As I see it, we have little to complain about as long as we keep paying the high cost of filling up.


Cameron said...

But Reach, why was it that a few months ago Utah had really cheap gas compared to the rest of the country?

Scott Hinrichs said...

For the same reason. Inventory replacement cost + the best available margin given market circumstances = price at the pump. The calculation works the same. Read the referenced Des News article if you want a quickie explanation of the various elements that go into the cost of gasoline inventory in Utah.

Since much of Utah's gasoline is extracted and refined locally, inventory costs vary somewhat from the national average. But demand also plays a big role. Demand was different last winter than it is right now. While the variety of factors make for a complex picture, the big picture is actually quite simple.

Cameron said...

Why do you suppose demand was different?

Scott Hinrichs said...

I think there are lots of factors that go into this, including the season, the weather, and the economy. Things will change. We have gone through a long dry spell that has increased travel, but already demand is down over the past week with the rainy weather we've been having.