Thursday, May 04, 2006

Gasoline Price Primer

Many don't understand why rising oil prices directly mean rising gasoline prices. Some think that even though the market price of oil is up, it doesn't cost the oil company any more to get it, they are producing it, not buying it on the market. To understand why rising market crude prices also mean oil companies have to charge more for gasoline, let's use an eBay example.

This is a from a post I made in a comment at Flopping Aces but I decided to copy in here in my own blog:

Let's say you have a well in your yard and a pump and you can get 10 barrels of oil a day out of it. It costs you 10 dollars to pump and deliver a barrel of oil. You put the oil on eBay to sell it. As people bid on the oil, the price goes up. People buy your oil for $15 dollars a barrel and you make $5 per transaction and life is good. Now some kids named China and India that have only been buying one or two barrels a day from you decide they need more. You are still only pumping 10 barrels a day. This means they must outbid other people for the oil. Now your oil auctions settle for $50 a barrel and you make $40 per transaction and life just got better.

Now lets say I decide to make gasoline out of one of my barrels and sell that instead of selling crude. The people that don’t know economics are going to say fine, it costs you $10 to pump the oil, you don’t need to raise the price of gas. Back to eBay …

Lets say you can produce bolts of fabric for $10 and are selling them on eBay and they are bringing $20 so you make $10 each. Now lets say your fabric becomes very popular and it is now selling for $70. You have also been using one bolt a day to make socks. You were selling raw fabric for $20 and you were making enough socks so you were getting $30 for the socks you could make out of that bolt of fabric. So after your wear and tear on equipment and your labor, you made what you thought was a fair profit on the gasoline, ehm, I mean socks.

Now your bolts of fabric are bringing $70. Are you going to sell a bolt’s worth of socks for $30? Are you going to spend all that labor and equipment cost to LOSE $40 a bolt compared to what you could just sell the crude for without refining it … I mean fabric for without sewing it?
No, of corse not. You are going to raise the price of your socks so that you make at least as much on the cloth from socks as you could selling the raw cloth … so the price of gasoline … I mean SOCKS goes up.


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