Myth Blaster: Exxon Record Making Profits Does Not Equal Price Gouging - An Economic Lesson for All Americans

AS the gas prices climb to $4 per gallon, Americans are wondering how will they make ends meet – Government refund check or not. If you didn’t get a check, you didn’t file your income tax. The amount is anywhere between $300 to $2,000. Tax free and not taxable on 2008 income tax returns.

Adam Kemp writes in his article Economics and Oil – Exxon is not Evil …

Every time Exxon releases their quarterly results showing record profits a debate erupts about what we should do about Big Oil. There seems to be a consensus among the masses that companies like Exxon are gouging customers for profit. We pay ever-increasing prices for gas while they’re raking in the money. It sure sounds like it’s their fault, but is it really?

First of all, let’s shed one big misconception: profit margins for oil companies are NOT abnormally high. According to Exxon’s latest SEC filing, its profit margins actually decreased year-to-year:
“Higher crude oil and natural gas realizations, driven by record worldwide crude oil prices, were partly offset by lower refining and chemical margins, lower production volumes and higher operating costs. [Source]
According to Yahoo! Finance, Exxon’s profit margin is about 10.82%. That means that for every dollar that Exxon makes, only about 10.82% is profit. That’s not much compared to other industries. For instance, Microsoft’s profit margin is about 28.33%. [1] Who is going after them for “excess profit”?
The real reason that Exxon is making so much money is not that they’re gouging consumers. The real reason is right there in the quote above: “record worldwide crude oil prices” (emphasis added). That brings us to misconception number two: Exxon does not set the price of oil.
This is the most important thing that people need to learn. The price of oil works much like the price of any other commodity in a capitalist, free-market society: supply and demand. Let’s review what that means.
We can analyze the market for a product by studying two curves. The first is the supply curve. It looks like figure 1 … As you’ll notice, the supply varies according to price, and vice versa. Likewise, as supply goes down, price goes up.
The other curve is the demand curve, seen in figure 2. This curve goes the other direction. As demand goes up, price goes down. Demand and price are directly related.
Notice that neither supply nor demand is fixed. Each varies with price. A lower price increases demand, which in turn decreases supply. A higher price decreases demand, which in turn increases supply.
You can more easily see the effects of changing the supply or demand by moving the lines relative to each other. [Figure 3] …
This is true in almost every industry. However, there are two more features of the oil industry which make it interesting. Most markets we think of are what you would call “elastic”. This means that producers can easily increase supply and consumers can easily decrease demand. This can be true of either supply or demand or both. The oil industry is different. Both supply and demand are inelastic.
Oil companies cannot merely decide to cut prices and increase production. They are limited to prohibitive cost of finding and producing oil, which (as we all know) is a finite resource. Thus Exxon cannot turn into Wal-Mart. They can’t simply play the high-volume, low-margin game. They sell what they can produce and no more. They are limited by conditions outside of their control. …
Remember Katrina? A hurricane knocked out 10% of the refining capacity in the US for a while (Source) and gas prices jumped by as much as 40 cents in one day (Source). Even then some were blaming oil companies for “gouging” consumers, but the reality is that supply dropped and demand did not. In fact, after Katrina the FTC did a study:
“The Federal Trade Commission said Monday there was limited evidence of gasoline price gouging. In the weeks after Hurricane Katrina, with soaring prices due mainly to market factors.” …
So we can’t blame the oil companies then who can we blame? Why is the price of oil so high, and why does it keep rising? There are several reasons.
The most obvious is that demand is continually threatened by violence in the Middle East. We are heavily dependent on the Middle East for our oil supply, and every time the stability of that region is threatened so is our oil supply. Our heavy-handed, interventionist foreign policy must be held partly to blame for this. Remember that price of oil was around $30 per barrel when Bush took office. Now, after Afghanistan and Iraq, it has rise to around $120 a barrel. [Source]
The effect of the threatened supply is exacerbated by the fact that oil is traded on the futures market. This allows people to purchase oil at a set price and collect it later. Likewise, it allows sellers to sell oil at a given price and deliver it later. … The market is betting on a grim future.
Another thing that influences the price of oil is the increasing weakness of the dollar. Exxon pointed out in their latest filing that they benefited from the weakness of the dollar. …
So how can we stop the price of oil from rising or make it go down? I can tell you that a “tax holiday” will not work. As many economist have pointed out (Source), the price is dictated by the supply and demand in the market today. Cutting the taxes will artificially drop the price, which will increase the demand until the price rises again. …
Clinton’s proposal to make the oil companies pay doesn’t work for the same reason, but it would be worse. However, there are two legitimate, fundamental ways to decrease the price of oil. Neither is easy.
The first is to decrease demand. This means buying less gas, through whatever means possible. …
The second is to increase supply. This means opening up more areas for oil exploration and building more refineries. Again, this is not easy, and it will take a long time as well. It also has the problem of being politically unpopular. …
Still, if we can do both of those things, there are two more things we can do to improve the situation. First, we need to stop stirring up trouble in the Middle East. Invading Iraq was a huge mistake, and invading Iran will only cause the price of oil to surge even higher. We must avoid conflict in that region, and we must find a way to restore stability.
Second, we need to stop destroying the dollar. That means that Congress and the President must stop excessive spending. …
Those are our options.

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[1] Wal-Mart’s net profit margin is 13.8% for every dollar made and that profit is shared by the associates on a quarterly basis.