Gasoline Prices and Energy Policy, True and False

The recent run-up in gasoline prices has led to a number of proposals by Washington politicians. It has also caused many people to be angry toward oil companies. What we are seeing looks like a replay of discussions and policy proposals that started in 1973 and continued throughout the 1970s. In the late 1970s, I became an energy economist because I saw President Carter devising some hugely destructive policies that perpetuated and extended the destruction that his predecessors, Presidents Gerald Ford and Richard Nixon, had brought to the energy sector. Most of what I said or wrote back then was the application of straightforward economic analysis to the energy issues of the day – very little of it was controversial among economists. And virtually everything I wrote then is applicable today. What follows is a brief look at eight controversies; each brief look could easily be expanded to a major column, but time does not permit. How does any of this relate to issues of war and peace? Read on.

Question One: Aren’t today’s higher gasoline prices due to oil-company greed?

In a literal sense, yes. If oil companies were not greedy – that is, if they were not trying to maximize profits for their stockholders – they could set prices a few pennies a gallon lower and still survive. But the claim is also misleading and relatively uninformative. Just a few weeks ago, gasoline prices were about 50 cents a gallon lower. Were oil companies not greedy then? Did they become greedy only in the last few weeks? As Charles Hooper and I point out in our book, Making Great Decisions in Business and Life, to explain a change in something, you must point to something else that changed. Oil-company greed, just like consumer greed – you want to get the best deal you can, don’t you? – is a constant. Therefore, it can’t explain the change in prices.

Question Two: So, what did change?

Two things, both of which made gasoline prices higher. Spot prices for crude oil (prices paid on the spot market) have risen by about $10 a barrel in the last few weeks. There are 42 gallons per barrel, and so the crude-price increase alone can account for about 24 cents of the roughly 50-cent increase in the price of gasoline. That’s a bit of a simplification. The reason is that a barrel of crude doesn’t produce only gasoline. That means that an increase in the demand for gasoline, which tends to happen at this time of the year, can cause an even higher increase than our 24-cent-per-gallon estimate. Second, as the Wall Street Journal pointed out in an excellent editorial (subscription required), the Bush energy bill is responsible for some of the increase. Why now? Because oil companies, afraid of being sued for using MTBE, the ingredient in gasoline that ethanol will replace, are using the congressional requirement that MTBE be used as a shield against lawsuits. The energy bill ends that requirement effective May 5, 2006, thus ending the shield. So companies are scrambling to buy ethanol to replace MTBE. The sudden increase in demand for ethanol has driven its price higher. The Energy Department estimates that "a few pennies" of the higher price of gasoline are due to the increase in the price of ethanol.

Question Three: Because this is all about supply and demand, doesn’t that mean that there’s nothing government can do to bring down gasoline prices while avoiding shortages?

Absolutely not. There’s a lot that government can do to bring down prices. Start with the main culprit: crude oil prices. Why did crude oil prices suddenly rise? The rise coincided with President Bush’s threats of war on Iran. When war is going on in an oil-producing region, it’s hard to produce as much oil. And when less oil is produced, its price rises a lot, even for a relatively small reduction in supply because what economists call the elasticity of demand for oil is relatively low. So if you want to blame one single person for the increase in the price of oil, blame a president who is trying to pick a fight with a government that poses very little threat to the United States.

Question Four: But wouldn’t a war with Iran, even if it reduced oil supplies, cause a price increase only in the future?

No. An anticipated reduction in the future oil supply will drive up the futures prices. Arbitrageurs, noting a higher futures price, will buy oil now at the lower spot price and sell it on the futures market at the same time, in order to make a profit. But the profit will be small because, as they buy it now, they bid up today’s spot price until the difference in prices between spot and future covers just interest, storage, and insurance. The arbitrageurs’ goal is simply to make money. But like most other participants in a free-market economy, they are doing society a huge service that is not part of their intent: by driving up today’s price, they give us an incentive to conserve today and save the oil until the time of a predicted lower supply. If some problem were to happen in the future, wouldn’t you want an early warning system? That’s what the futures market is.

Question Five: Then doesn’t this mean that that the Senate Judiciary Committee, which voted last week to amend the antitrust laws to make it illegal for oil and gas companies to withhold oil from the market with the intent of driving up prices, is insane?

No, but they do seem stuck on stupid. Right now, congressmen, with some exceptions, seem to be trying to figure out where the American people want to go and then getting in front to lead them there. They don’t seem to actually be thinking about the problem.

Question Six: Wouldn’t a "windfall" profits tax on oil companies be a good idea?

Let’s see. We’re upset that oil prices are so high, and so the solution is to tax the companies that produce oil? Taxing a particular industry discourages more production from that industry. So, the tax’s effect on prices will be to increase them. It will also strengthen the power of OPEC.

Question Seven: But isn’t it unfair to let oil companies take advantage of higher oil prices?

No. They took a risk. There was no guarantee that prices would rise. And if the government taxes them more on their profits on inventory, they have less of an incentive to produce in the future. That seems like a bad consequence. Moreover, it’s stunning to see people who own houses that have tripled in value in the last 15 years argue that oil companies should be taxed on their higher profits. Would they advocate that they themselves pay a special tax when they sell their homes? The analogy is imperfect, but in a direction that makes my case stronger. A special windfall profits tax on oil will reduce its supply and the make the world price of oil higher. A windfall profits tax on housing would reduce its supply, too, but with less-drastic effects. There is no OHEC (Organization of Housing Exporting Countries) waiting to take advantage of the situation.

Question Eight: But doesn’t it at least make sense for Congress and the rest of us to excoriate oil company executives, especially those at large oil companies?

To the extent that the oil companies are large, it’s because they’re producing more. If we’re upset about high prices, it makes no sense to attack those who, by their very productive activities, are making oil more plentiful than otherwise. If a minister is upset about the low turnout of his congregation, should he express his anger at those who bothered to attend?

Copyright © 2006 by David R. Henderson. Requests for permission to reprint should be directed to the author or

Author: David R. Henderson

David R. Henderson is a research fellow with the Hoover Institution and an emeritus professor of economics in the Graduate School of Business and Public Policy at the Naval Postgraduate School. He is author of The Joy of Freedom: An Economist’s Odyssey and co-author, with Charles L. Hooper, of Making Great Decisions in Business and Life(Chicago Park Press). His latest book is The Concise Encyclopedia of Economics (Liberty Fund, 2008). He has appeared on The O’Reilly Factor, the Jim Lehrer Newshour, CNN, MSNBC, RT, Fox Business Channel, and C-SPAN. He has had over 100 articles published in Fortune, the Wall Street Journal, Red Herring, Barron’s, National Review, Reason, the Los Angeles Times, USA Today, The Hill, and the Christian Science Monitor. He has also testified before the House Ways and Means Committee, the Senate Armed Services Committee, and the Senate Committee on Labor and Human Resources. He blogs at