A word about gasoline prices

Gasoline prices are high, and have remained high since the spike upward in the futures market price for unleaded gas that occurred in the wake of Hurricane Katrina. Faced with the prospect that Gulf of Mexico refineries would go off line, the anticipated pricing of refined gas products jumped. For unleaded gasoline, the price for deliveries of gasoline jumped by almost $1.00 from the $1.90 range to $2.80 in intraday trading.

In the wake of this increase, prices at the pump increased, within a day or two, to by almost the same amount to their current levels.

Then, a funny thing happened. As is often the case, the brief panic ended, traders calmed down, and the futures price receded to its current level of approximately $2.00, just a bit higher than the pre-Katrina levels. However, prices at the pump have not budged, so the question is why?

It is not really surprising, and it does not reflect a conspiracy on the part of the oil companies, though they could fix it if they wanted to. It is a function of normal retail pricing behavior.

As long as the underlying cost of gasoline at the wholesale level is stable, prices at the pump fall to a level where retailers are making a reasonable profit. There is no incentive for one station owner to drop prices to steal market share from others, as their profit margin would drop below acceptable levels. There is also no incentive to increase prices, as station owners fear the loss of market share to others.

When the cost jumped, all owners pushed their price up to sustain their level of profitability relative to the new anticipated wholesale price. They did not keep their price steady, as they had no way of knowing how long the price spike would last. In this case, even as prices rose, demand increased rather than declining, as drivers kept their tanks topped off going into the Labor Day weekend, fearing being caught without being able to find gas if shortages occurred.

As things settled down, the futures market price receded, demand moderated, but prices remained high. Why?

Retail pricing for gasoline is not that different than for other products, except that vendors tend to only sell one product, and therefore their pricing actions are highly cost sensitive. As costs rise, prices are pushed up to cover the cost and sustain profit margins. As costs fall, however, and profit margins increase, prices will remain high until competitive pressures force each retailer to reduce prices to protect their market share.

Simply stated, costs drive prices up, competition drives them down. No different from airline tickets, or cars for that matter.

What are the policy implications of all of this? Several governors are considering cutting state gas taxes to reduce the burden on consumers, however this is unlikely to achieve the desired result of lower retail prices. Gas taxes are just one part of the price at the pump, and if lower wholesale prices won't bring down prices, neither will lower gas taxes. In fact, a reduced gas tax will likely just increase the retailer profit.

No, if you want to bring down prices, help stimulate competition: start a price war. Prices will come down as retailers feel the need to reduce prices to protect their market share and their revenues. Convince one company to reduce prices and the rest will follow suit. How? Sue them for price gouging. Shame them through public disclosure. Appeal to their sense of patriotism and shared sacrifice.

In the absence of any action, prices will come back down. Sooner or later. Markets will work. They almost always do.

For further reading, the General Accounting Office prepared a report on California Gasoline Pricing at the request of Diane Feinstein in April, 2000.