Mendoza School of Business

A big cause of the high price of gasoline

Published: May 18, 2008 / Author: John Business

Here is a test question for you: The next time you find yourself irritated by the price of gasoline, you need to remind yourself of how much — or little — of that nearly $4 per gallon charge is the oil company’s profit. How much is that profit, anyway?

As a frame of reference, start with the amount of profit for government carved out of the purchase price — roughly 50 cents per gallon from various taxes imposed. So what do you think the oil company’s profit is? (Assume an integrated major oil company that even owns the filling station, so we don’t have to separate producer, refiner and retailer profit. That is, we identify profit for the whole oil/gasoline industry out of the purchase price.) Would Big Oil make a profit of 60 cents, 70 cents, $1, $1.50?

No. Try 25 cents.

That is correct. With an industry-wide average net profit margin on the retail sale price of about 8 percent, the net profit on your gallon of gas is about a quarter, give or take a penny or two depending on the size of the oil company. (About 3 cents net goes to an independently owned station, leaving 22 cents for Big Oil, but the total is still a quarter.)

An accurate understanding of oil industry profit levels dramatizes that it is misguided to accuse the oil industry of price gouging. Beyond the cited 8 percent profit on sales, the industry’s return on investment is right at the average across all of American industry — about 25 percent. And these profit indices were much lower during the recent lean years in the oil business.

What of ExxonMobil’s “obscene” $40 billion total profit last year? Isn’t it natural for the largest
corporation to earn the largest profit? Anything other than that would be a major upset. Moreover, record profits year after year are the natural order of things in business, reflecting normal growth.

Since the first “oil crisis” of the 1970s, there have been numerous major federal investigations of alleged oil industry price gouging and price collusion. How many times have the big oil firms been found guilty of gouging or collusion? The answer: never.

No, the main cause of high gasoline prices, other than plain old supply and demand, is policy errors by government. Of course, explosive economic growth in China and India is the main driver on the worldwide demand side, but blunders by the U.S. government have severely aggravated the domestic problem. Prominently, the bottle-neck at the refinery level is explained by onerous and expensive regulations, especially at the state and local government levels, that make it somewhere between unprofitable and impossible to build an oil refinery in this country. Therefore, none have been built here in more than 30 years. So when you hear about oil refinery capacity shortfall caused by maintenance and repair problems, ask yourself whether all this would be happening if we had more new refineries and fewer old ones that need to be patched up all the time.

Overly strict government environmental regulations prevent oil exploration and drilling in the U.S. or off our coasts. We’ve got Cuba and China drilling off the Florida coast in the Gulf of Mexico where American oil companies are not permitted to drill.

As for Alaska’s Arctic National Wildlife Refuge, out of tens of thousands of square miles, 1,000 acres were to be set aside for an oil field, but this has been thwarted by Congress. The prospective estimated volume has been dismissed by critics as only half of our annual demand, but that translates into a 5 percent yearly supply boost for a decade, which would materially affect prices as well as our oil independence.

No nuclear power plants have been constructed in the United States for more than 30 years because of stifling regulation. This also constricts our total energy capacity with corresponding impact on energy prices. Add to this litany the errors of monetary policy by the Federal Reserve in recent years. Had our dollar maintained parity with the euro, prices at the gas pump would be about $2 per gallon today.

There is more, to be sure, such as regulations that mandate more than 20 gasoline formulas or
“boutique” blends to meet different environmental criteria in various governmental jurisdictions around the country. This hodgepodge of laws drives gasoline prices higher by curtailing economies of scale.

Note that all the cited policy mistakes are those of one political camp. For decades the liberal
Democrats have done everything they could to raise domestic oil and gasoline prices, and now that those higher prices have come home to roost, the Democrats pretend not to like them. Currently, their anti-oil industry propaganda campaign is on track to create the abysmal public ignorance that is a precondition for the same base level of public policy, and policy outcomes. This is our real national test, and the forecast is ominous.



Topics: Mendoza, Undergrad