Gasoline Price Economics

Just like the white rabbit in Alice in Wonderland, my wife and I are late for an important date! I pull up to the Shell pump and go in and tell the cashier I want \$30 on pump six. I go out and start to pump and the pump doesn’t work. I go back in, shove the door open and tell the cashier to turn on the blankety (I didn’t swear, I said “blankety) machine and immediately return to the pump, but nothing happens.

I go back into the station and the cashier is ready for me this time. He lets me spout off while he crosses his hands on his ample belly and smiles. When I have run out of steam, he says, “You’re on pump nine not six.” A sudden “what fool would tell the cashier the wrong pump number” feeling cruises through my muscle skeleton with lightning speed.” The cashier is now sporting a Cheshire cat smile. I smile back and say “Okay, then \$45 on pump nine, please.”

The cashier looks at me triumphantly and says. “Someone pumped gas on number six and left. You have \$8.43 left, and I’ll transfer it to pump nine.”

So you can see that I have been waiting for some time for prices to come down so Shell’s revenues take a hit.

The Economics of the fall in Gas Prices in the last month.

Every principles student at Lewis University can explain what is going on with gas prices and the global impact it is having on the United States. Simple Supply and Demand theory and the Profit Formula explain it all. Let’s review both.

The Law of Demand states: that per unit price and quantity are inversely related. Common sense tells you that as prices go up, you buy less of the product and substitute other goods for it.

The Law of Supply states that as price per unit increases as the quantity increases. This is common sense too. Your revenue as a seller increases (price times quantity) as the price increases.

If prices are too high then the supplier has a surplus and reduces prices, and if prices are too low the shortages force demanders to bid prices up. The result when there is no market monopoly power or government intervention is an equilibrium price where supply and demand are equal.

The graph shows the current equilibrium price and model.

Now the interesting thing to note is that if the number of suppliers increase the whole supply curve will shift to the right, since at every price suppliers are willing to supply more.

Of course, the opposite holds true, too. If the suppliers cut back on supply the price will rise, because the whole supply curve will shift to the left.

Demand works similarly, if the demand increases the whole curve increases upward and to the right. The price will increase. If the demand decreases then the whole curve shifts downward and to the left, and the price decreases.

What going on today?

First, we have cut back on the demand for gas by increasing our average fuel economy. The tax credit for trading in fuel guzzlers and destroying them was helpful, as well as, many of our energy efficiency incentives.

Second, the new methods of extracting oil in the U.S. have dramatically increased supply. U.S. crude oil production increased from an average of 7.4 million bbl/d in 2013 to 8.6 million bbl/d in 2014, and is expected to increase to 9.3 million bbl/d in 2015.

Saudi Arabia, the largest producer, produces 9.6 bbl/d which is 11.4% of the world production and 31.8% of the Oil Producing and Exporting Countries cartel. The reemergence of the U.S. as a top oil producer has increased supplies of oil dramatically and reduced the world’s dependence on OPEC.

Third, ISIS has been selling stolen oil across the Turkish and Iraq borders for a fraction of the world price, and nations that have experienced turmoil have come back on production like Libya and Iraq.

How does this effect Gas prices?

Each dollar of you gas goes to the following:

• Taxes: 13 cents
• Distribution and Marketing: 8 cents
• Refining: 14 cents
• Crude oil: 65 cents

As you can see, when the price of a barrel of oil decreases from the record high in July 11, 2008 of \$147 per barrel, to the current \$54.3 WTI price there is a heck of an impact on your gas price.

The Saudis fight back!

Let’s not forget the current Arabian leaders were educated by some of the best economists at some of the best universities in the world. They have two options.

They could cut back supplies forcing the price up, or keep producing at current levels forcing the price down. (The Saudis are called a swing producer since they can create a surplus or shortage at will.)

Let’s take a look at the first strategy, which is the one they have generally used during times of high supply and dropping prices.

The problem with this strategy today is that it doesn’t attack the core problem. The U.S. has now regained energy independence with newer production methods of forcing oil out of North Dakota and Oklahoma rocks, at a high rate of production.

So they have made the decision to break the back of the U.S. production by running us out of business. This means they are increasing supply and thus driving the price of oil down. The objective is simple.

A firm is in business to make a profit which is Total Revenue minus Total Cost.

Profit ( ∏ ) = TR –TC

Where TR = Price times Quantity

The Saudis believe the current revenues required to break even for U.S. production are \$90 a barrel. That means if they can force the price down (today it is at \$53 a barrel), and keep it there for a while the U.S. companies that are paying a higher extraction cost compared to the OPEC nations. Then, the OPEC nations will have to go out of business.

Implications of this Strategy

• More affordable oil is good news for us. Cheaper gasoline means more disposable income, and lower shipping costs which leads to lower prices.
• Low energy costs tend to boost economic growth, potentially spurring job creation in an economy that has failed to produce rising wages.
• The U.S. Energy Information Administration says that average household will save about \$362 per household this winter, thanks to lower oil costs and milder weather.
• Energy intensive industries, from airlines to agriculture, will see lower costs from falling fuel prices — and, in theory, they should pass those costs on to consumers.

Does the Saudi Strategy have Potential flaws?

There are two potential major flaws in the Saudi strategy. First, the break-even price of producing scale oil in the U.S. may be lower than \$90. It could be a low as \$40 which would blow the Saudi strategy out of the water. The difference in numbers according to some experts is that the leases for the land in North Dakota and other fracking states are already in place and will not go up. The Saudis calculations include an assumption that the leases cost will increase as more shale oil is produced. It is clear that through 2016 that US production will continue to increase, so the Saudis may have to sustain the low prices for a while.

The second problem for the Sauidis strategy is much larger. The OPEC countries have built their governmental budgets on the basis of oil exports. The oil prices needed to sustain those budgets are shown in the table.

So, it is not surprising that the financial headlines read on December 16, 2014, stock markets in the Persian Gulf got drilled Sunday as worries about further price declines grew. The Dubai stock index fell 7.6% Sunday, the equivalent of a 1,313-point plunge in the Dow Jones industrial average. The Saudi Arabian market fell 3.3%

As you can see, the Saudi strategy is not painless for them. At some point they may have to abandon the strategy, if cutting back on government services and subsides cause social unrest at home.

Other Political Implications

ISIS has been selling stolen oil from Syrian wells for some time now. Since it is embargoed oil they have to sell it on the black market twenty-five cents on the dollar. Effectively the fall in the price of oil puts their sales at \$15 to \$20 a barrel and crimps their ability to fund their aggression.

Another major political throne to the U.S. is also hurting. Fifty percent of the Russian federal budget comes from natural resource export taxes. The breakeven point for the Russian budget is \$107 per barrel.

Putin will most likely continue to cause the Ukraine problems, but he is looking over his shoulder at his buddies that are losing billions due to sanctions. Putin will get much more domestic unrest when he will have to cut the budgets due to the oil price fallout. The Russian monetary branch was in the news last week, as it tried to keep the ruble from falling to record lows, after it said it would not intervene.

Venezuela, already facing serious fiscal woes and rampant inflation, needs oil at \$151 a barrel next year to balance its budget, according to the data. They may get a little friendlier toward us, as a result.

Iran, which has yet to agree to curb development of nuclear weapons, and heavily subsidizes gasoline for its citizens needs oil at \$131 a barrel.

Libya looks as if it could be facing a serious fiscal hole, with its breakeven for 2015 at \$315.

A domestic governmental implication is that 13% each dollar spent on gas goes to the taxes to fund our roads. The dramatic drop in the price of gas is going to have a significant impact on those revenues.

Conclusion

There you have it. A simple general education understanding of the basic economic principles of supply and demand and the profit formula puts the world in perspective.