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 consumers 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-over-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%. 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 (note: neither the supply curve nor the demand curve is necessarily linear; they are shown that way for simplification). As you'll notice, the supply varies according to price, and vice versa. As supply goes up, price goes down (or, as price goes down, supply goes up). Likewise, as supply goes down, price goes up (or, as price goes up, supply goes down). Supply and price are inversely related.

The other curve is the demand curve, seen in figure 2. This curve goes the other direction. As demand goes up, price goes up. As demand goes down, 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. Somewhere along those two curves there is an intersection at which point a balance is reached. That is called the price point (figure 3). That is the point at which the market is in balance.

You can more easily see the effects of changing the supply or demand by moving the lines relative to each other. Increasing the demand moves the demand curve to the right, which leads to a higher price point. Decreasing the supply moves the supply curve to the left, which has the same effect (a higher price). Likewise, increasing supply moves the supply curve to the right (decreasing the price), while decreasing the demand moves the demand curve to the left (also decreasing the price).

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 by the 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.

At the same time, the demand is equally inflexible. People need gas. They need it to get to work, to heat their homes, to transport things from place to place, to produce electricity, and so on. We have grown heavily dependent on oil in a way that does not allow us to easily cut back.

The effect of inelasticity on the supply and demand curves is a much steeper slope. Whereas most industries might look like figure 3, the oil industry would look more like figure 4. Consider the effects of price with that new graph. Due to the steep slopes of the curves, a small change in either supply or demand can cause a large change in price.

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.

As part of a two-prong study for Congress, the FTC also found no instances of illegal price manipulation by refiners, wholesalers and retailers since 2002, such as cutting back on refining capacity or diverting gasoline to foreign markets. (Source)

So if 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 supply of oil. Our heavy-handed, interventionist foreign policy must be held partly to blame for this. Remember that the price of oil was around $30 a barrel when Bush took office. Now, after Afghanistan and Iraq, it has risen to around $120 a barrel.

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. There are various reasons this benefits either the seller or the buyer (usually the buyer in this case), but the important result here is that the price of oil reflects a prediction of what the market conditions will be at some point in the future. Right now we're seeing a consensus that the supply will fall due to the various conflicts in the Middle East, and so the price goes up ahead of those conditions. 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 benefitted from the weakness of the dollar. This is true of most companies which sell overseas. Even if the prices in local currency remain the same, the exchange rate changes such that the price in dollars is increasing. Thus Exxon can sell oil overseas at a steady price and make more money in US dollars. Unfortunately for them (and for us) the weakness of the dollar means that those huge profits are worth less than they used to be. If the dollar recovers then they'll come out ahead, but if it continues to fall then they won't be so happy anymore.

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 economists 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. They may or may not go as high as they were, but they will probably be close. The "savings" will be minimal at best. Meanwhile, the difference will go to the oil companies instead of going towards repairing the roads we're driving on.

Clinton's proposal to make the oil companies pay doesn't work for the same reason, but it would be worse. A tax on the oil companies would be viewed by them as an expense. In order to keep the stockholders happy (which is their duty as a company) they would have to increase the price to maintain their profit margins. Again, the price would not drop by as much as the taxes were cut.

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. Public transportation, better fuel efficiency, alternative fuels, etc. This is hard, and it will take a long time. It needs to happen, though.

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. We also need to be clear that this method is not nearly as effective as the first. We almost definitely cannot produce enough oil to achieve actual independence from Middle East oil. Also, the price of oil is global, so even if we produce a higher percentage in America a threatened supply in the Middle East will increase the price everywhere, including here. It doesn't matter where the oil is produced. Any change in supply worldwide will affect the price worldwide. We live in a global economy.

Still, if we can do both of those things (the first being the most important) then we may get out of this mess. In the meantime, 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 value of the dollar. That means that Congress and the President must stop excessive spending. When we spend money we don't have the value of our money goes down for everyone, and that reflects in the price of oil just as it reflects in the price of everything else.

Those are our options. Those are the things we must focus on and we must accomplish. If instead we choose to keep blaming the oil companies, implementing disastrous foreign policies that promote instability in the Middle East, destroying the value of the dollar, and using temporary and ineffective workarounds that ignore the proper workings of the market then we will be stuck in this mess for a long time to come.