The Real Reasons Why Gas is So Expensive

Gas is expensive. Yes, I have been told that I have a firm grasp of the obvious.

So what do we do about it? I know! Let's go after those evil money grubbing greedy oil companies! Nearly every day I hear something along these lines said by otherwise intelligent people, and being a firstborn, I have an overwhelming innate need for accuracy and truth. So let's talk about reality.

Myth #1: Gas stations are making record profits, gouging consumers.

Reality: Your local gas stations typically makes a 1-5% margin on gasoline, and almost always closer to 1%. When prices rise quickly, sometimes stations will price it at no margin at all. I guarantee that local stations are not happy about the current situation.

Myth #2: Oil companies are making record profits, gouging consumers.

Reality: This is true in terms of dollars earned, but lets look at this a little more closely. First of all, oil companies do not set the price for their product. There is no monopoly. If there were, then the Texas economy would not have tanked int he '80s and '90s when gas prices were so much lower. The fact of the matter is when you're dealing with minerals and natural resources, the exploration and equipment is extraordinarily expensive. When prices go down, you can actually lose money after subtracting the costs from your revenue. And when prices go up, suddenly those expenses are worth it. I have a financial planning client whose family owns a silver mine and did not operate it for years because the price of silver was too low. Guess what--oil is no different.

Currently oil companies are making a 9.7% profit margin. Not bad, but hardly the 25% profit margin that Google makes. Obviously Google is gouging us and we should go after them!

Oil companies also have some pretty nice tax breaks. They could do without some of these, but there are legitimate reasons for others. For example, if you buy a piece of property and construct a building on it, you have improved the property and expect to make a profit, which is taxed. With oil it's the exact opposite. Once you have extracted the oil the property becomes worthless. This is why oil companies can deduct the price of exploration and equipment, since its value will eventually evaporate.

Myth #3: OPEC and other oil producing contries are making record profits and gouging consumers.

Reality: Once again, they just pump it and sell it for whatever the market will bear. OPEC has tried to control the market by reducing production, but when the price is good they all cheat.

So who is gouging consumers? Surprise! No one.

Then why are gas prices going through the roof? A combination of factors, sort of a perfect storm.

First, you have the increase in worldwide demand. China and India get mentioned a lot. However, demand has not doubled in the last two years, so this is hardly the full reason, but it definitely contributes. OPEC itself has done several studies and determined that current demand should price oil at about $60 per barrel. So something more is afoot.

Second, the strength of the dollar is falling. This sounds like a bad thing, but what it really means is that U.S. products are less expensive for foreign consumers to purchase, boosting our exports. However, if you are an investor you don't want to see your purchasing power shrink, so keeping your money in dollars is a losing proposition until it levels out. So where to put that money? Ah, I know! Something that keeps its value (at least in the current market--see first point): oil (and gold and other commodities). And with more investors wanting to buy oil futures (more on these below) to protect their money's purchasing power, the price goes up.

Third, there are concerns about oil supplies. Of course, there are always concerns, since the majority of oil is pumped in less than stable parts of the world. So instability in far flung places like Iraq, Iran, Nigeria, Venezuela, etc. scares investors into thinking that oil may become scarcer. So they buy oil futues to ensure that they can buy oil at a given price, regardless of the actual price. Think of it like a pre-payment plan. (Of course, if oil goes down its a real bummer for these investors.)

You may also have heard about "peak oil." This theory essentially says that we have now extracted more than half of all oil on earth and so it's only going to get scarcer going forward. Whether true or false, it scares people, making them willing to pay more for it.

So will gas stay at its current price? Will it only get worse? The law of supply and demand still exists. With prices as high as they are other sources like oil shale, etc. become cost effective, as do alternative fuels. Within 10 years we will probably be awash in energy. Hopefully prices will come down long before then, but they will come down, probably within the next 12 months. How low? I can't even guess, but for my job's sake I hope it's much lower and soon. But for now whenever you hear someone complain and say we should go after the oil companies, just roll your eyes. You now know the truth.