Oil Prices and Adam Smith (Pt. 1)

Doug over at Bogus Gold wrote a post yesterday defending oil company profits during this time of rapidly rising gas prices. His thoughtful post plus this one by Pat Cleary over at RedState.com invoke various free market principles to justify what is widely perceived as profiteering by oil companies. Now I'm no economist, so I may be way off base with this post, but I believe both Doug's argument and Pat's contain serious flaws.

Doug's basic argument boils down to the old "Invisible Hand" argument. The argument goes essentially that markets are self-correcting, profits drive competition which drives innovation which drives more profits and so on with both businesses (through profits) and consumers (through better and/or cheaper products) benefiting. Pat's argument is that oil prices are rising due to factors beyond the control of the oil companies and therefore they cannot be held responsible for price increases. Let's deal with that second argument first.

If it were true that gas prices reflected the price of crude oil then oil company profits should remain relatively stable- just like those of most blue chip industries. That is clearly not the case, however. The fact that oil companies are reaping record profits as oil prices increase indicates that they are raising gas prices faster than can be accounted for by the price of oil alone. Admittedly, oil prices are set by a volatile futures market, so occasional large profits are to be expected since sometimes fears of shortages are over exaggerated and therefore the commodity becomes temporarily over valued. We're not seeing occasional profit spikes, however, but sustained massive profit margins for more than a year now. Also record profits are not limited to one company as one would expect in a normal market situation where the current market leader would take the largest share of the profits. Instead this seems to be generally true of all players in the industry.

Lack of refinery capacity also runs into this "fake shortage" problem detailed in the last paragraph-gas prices simply do not directly relate to the production cost of gas as oil company profits make clear. There are additional considerations for this one which I'll get into more fully in the next post when I address Doug's argument.