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Why Is Oil Priced The Way That It Is?

·5 min read

People who should know better are still deflecting the blame for high oil prices onto the oil companies. There is still a widespread misunderstanding of how oil and gas are priced.

Further, I find that a lot of people think the fact that gasoline prices are at record highs along with oil company profits means oil companies are definitely gouging consumers. “Explain this!”, they will say, while showing me some link about Chevron’s profits (as if this revelation will finally make me see the light).

So I thought of a story to help readers understand.

I like to use analogies to break down complex topics into simple and relatable problems. Obviously an analogy isn’t perfect, but its purpose is merely to increase understanding.

I shared the following story on Facebook last month, and it resonated with people. Some suggested that it should be an article, so here it is.

The Chicken Farmer

Imagine that you raise chickens. You have a large operation, so you don’t sell your individual chickens to your neighbors. You take them to a market where they are auctioned off each week.

Sometimes the demand for chicken is strong. Maybe there is a season when people tend to eat more chicken. The price people are willing to pay — because everyone wants a chicken — goes up and you make more money.

Sometimes supplies are short. Perhaps your fellow chicken farmers had some bad luck with bird flu and they have fewer chickens for sale. If supplies are short and demand is strong, then you make more money.

There may be times when you make far more money than it cost you to raise your chickens. A windfall, if you will. People get angry with you for making more money at their expense. They may demand that you lower your price for your chickens, even though that price is being set at the auction.

Then there may be times when there is a bumper crop of chickens, but because of changing preferences, the public has decided to eat fish. Perhaps there is a widespread belief that the future belongs to the fish farmers.

You take your chickens to market, but you get far less for them than it cost you to raise them. You lose a lot of money. If you lose too much, you decide to exit the chicken business. This is going to impact chicken supplies in the future. But hey, as long as everyone is eating fish, no problem, right?

Whom did you gouge in this process? Sure, there are times when chicken prices were high and you were making a lot of money at the expense of your fellow citizens.

But that’s because people in that chicken market were all trying to get chicken. They were competitively bidding up to what they were willing to pay, not shelling out more because you decided to sharply raise the price of chicken.

Of course, it’s even worse if they don’t have any alternatives. But it’s not you, the chicken farmer, who is taking advantage of people. If anything, those buying chicken could complain about the way chickens are sold.

Envisioning A Different Model

Perhaps there is a different way of selling chickens that will allow the farmer to earn a profit, and the customer to pay a “fair” price. Let’s say you decide you don’t need to make so much money and you decide to sell your chickens based on how much it cost you to raise them.

I can predict two things based on this model.

First, there will be those who will buy them and then simply turn around and sell them at the chicken auction. The supply and demand-based profit margin will move from you to them.

Related: Europe’s Big And Expensive Energy Mistake

Another way to think about this is to think about your home. Let’s say prices in your neighborhood have soared. Instead of selling the home you bought for $200,000 at market value — which, let’s say, is $600,000 — you decide you don’t need to make that much money. You are content to sell your home for $250,000. Buyers will immediately pounce on your home, which is still valued at $600,000. You just gave the profit margin on your home to someone else, who can buy your home for $250,000 and sell it for $600,000.

Second, there will still be times when chicken prices plummet. Neighbors who may have been happy to pay you a small profit margin for your chickens when market prices were high will be far less willing to pay you over market for your chickens if the price falls.

When the chicken price plunges, they will buy at the chicken market, and you will be forced to lower your prices. You will still lose money, but now you will have less profit in other years to offset those losses.

That’s How Oil Is Priced

This analogy should give you an idea of how the oil and gas markets work. It’s also how many other commodities (like wheat and copper) are priced.

The COVID-19 pandemic disrupted supply chains in many of these commodities, which reduced supplies. That is the biggest reason why the prices of so many commodities soared, and this was a major factor fueling inflation.

Yes, this leads to huge profits for some of these companies, but there are other times when prices cut the other direction.

In a recent Forbes article, I noted that ExxonMobil (NYSE: XOM) made $25.8 billion in the past 12 months. People are outraged. But in 2020, the company lost $22.4 billion, and many smaller oil producers went bankrupt.

The people outraged about their profits today didn’t care about all those 2020 bankruptcies. Yet those bankruptcies from 2020 helped set the stage for supply shortages today.

We could change the way oil and gas are priced (or we could ration supplies), but there would be consequences. For example, Venezuela holds the price of gasoline well below market value for its citizens. But that has effectively destroyed the country’s oil industry.

Perhaps there is another way. It would also have to protect vital industries when prices crash. But it’s not as simple as “prices are high because companies are gouging us,” That’s why appealing to the “patriotic duty” of oil companies to lower prices is nonsensical — because that’s not the way gasoline priced.

By Robert Rapier

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