By John W. Schoen Senior Producer

Last week’s Capitol Hill appearance by oil company CEOs — to explain the industry’s record profits — left many readers confused about one basic question. Chad in Des Moines wants to know: how can those record profits not be the result of price gouging? And Catherine in Seattle has here own theories about what's going on in the oil markets.

I just don't understand how the oil companies could have record profits during the third quarter of 2005 yet, as consumers, there was no price gouging going on. It just seems like the consumer got taken advantage of during all the natural disasters this year. Can you shed any light on the situation?
Chad K -- Des Moines, Iowa

Well, we'll try. Most people have made up their minds on this subject, but it seems like yours is still open.

While some countries subsidize gasoline prices (or heavily tax them to encourage conservation), ours does not. (Our government does tinker with the market for some commodities like corn, through subsidies, to encourage production and stabilize prices.) But as long as market pricing prevails, oil companies make their money by extracting and selling a natural resource that is priced like any other raw material traded on the open market.

So an oil company is no different than, say, a gold mining company. The price of gold has little to do with how much it costs to find and produce it — it's set by supply and demand. So most gold companies produce more when gold prices are high than they do when gold prices are low. (Which makes sense to us.)

You might do the same thing if you were selling your house and retiring to Florida: you'd probably wait until housing demand is strong — and prices are high — to sell. But if that strong market encouraged builders to put up a lot more houses, or if a recession or high interest rates scared away buyers, you might not get as good a price.

That's pretty much what has happened with the oil industry. In 1998, with global oil demand sharply lower, thanks in part to a major economic slowdown in Asia, oil prices crashed to $10 a barrel. (Few people remember this, or were even aware of it, because it got nowhere near as much press coverage as the recent rise in gasoline prices.) To cut costs, oil companies merged (that's why we have ExxonMobil and ChevronTexaco) and sharply cut back their investments in drilling for new oil. With oil selling for $10 a barrel, it just didn't make economic sense.

Oil prices eventually began rising again as the global economy recovered. But it takes years from the time you invest in looking for oil to the time you can pump it out of the ground. So even in places where there are still plenty of reserves (oil underground) like the Middle East, oil production (how much you get out of the ground per day) didn't grow fast enough to cover the growth in demand. (The same scenario, with somewhat different causes, is more or less true with gasoline refining capacity.)

By the early 2000s, just as investment in new oil production had slowed, demand for oil began taking off — especially in developing countries like China and India that have presided over booming economies. (Which is a good thing, by the way. If the Chinese weren't able to afford to buy billions of dollars of U.S. Treasury debt to make up for our budget deficit, we'd likely be looking at much higher U.S. interest rates — or worse. But that’s another answer for another day.)

When demand for oil or gasoline grow more quickly than production capacity, supplies get tighter. And, with the market setting prices, anyone who needs a barrel of oil or a tanker of gasoline will bid whatever it takes to buy it.

As long as we have market-driven pricing, it's very tough to define "price gouging." Lots of states have tried. But any retailer accused of price gouging has a pretty strong defense by simply pointing to the rise in the market price of oil and wholesale gasoline. If you haven't exceeded that rise, you're not gouging. And you can't exactly charge the oil trader in the commodities exchange with gouging any more than you could an investor who gets $395 for a share of Google that he bought for $100.

As for oil company profits, if you're an oil producer or gasoline refiner and market demand has raised the price of your product, and your cost of producing that product didn't go up, of course you're looking at a huge profit. Whether that's a good thing (because it gives you more money to invest in producing more product) or a bad thing (because most of that money seems to be going to shareholders as dividends, and not into expanded production) or whether government should step in with higher taxes (to give the money back to people are who suffering from high energy prices) depends on your political point of view.  If you're a real cynic, you'd say oil producers and refiners are deliberately not investing in new production because they like prices just where they are. (There may be some truth to that, but we don't believe that's the whole story.)

One more point: the oil industry's overall profit is about average for American industries. But because of all that oil industry consolidation we mentioned, profits are a lot bigger for the each of the biggest companies — the so-called "majors" like ExxonMobil and Chevron. All the profits of all U.S. oil producers taken together, for example, are much less than all the profits of all the pharmaceutical companies out there. But because there are many fewer oil companies and each one is much bigger, their individual corporate profits look gargantuan.

Isn't it entirely possible that the artificially contrived retail fuel costs in this country are simply price gouging that results in energy companies' record profits? Isn't it entirely possible that the gigantic spike to more than $3 was just to make the masses more comfortable with the still-gouging $2.10 a gallon? Isn't it entirely possible that the hurricanes were simply excuses to shut down refineries to artificially increase prices just as the energy companies planned in the late 1990s? Why is it that domestic oil costs far less than imported crude? In a word, Bush-sanctioned greed.
Catherine D. -- Seattle, WA

Two can play this game:

Isn’t it entirely possible that there’s a group of rich white men who secretly meet every week in a conference room in Houston and decide just how badly they’re going to screw American consumers, after which they have a big laugh and fly home on their corporate jets paid with money stolen from their corporate treasuries? Isn’t it entirely possible that George Bush secretly owns a big chunk of ExxonMobil and Chevron (breaking all federal financial disclosure regulations) and is pursuing energy policies with the sole purpose of engorging his personal net worth and enriching a cabal of incredibly powerful Texas oil cronies?

Isn’t it entirely possible that Dick Cheney secretly flies to the Middle East once a month to confer with OPEC ministers to help his old buddies at Halliburton? Isn’t it entirely possible that global warming is all a fraud, secretly concocted by liberal academics looking for ways to win more grant money? Isn’t it entirely possible that avian flu is a hoax cooked up by drug companies that make the anti-viral drugs needed to treat it?

Here’s one more: Isn’t it possible that oil and gasoline prices are rising because production hasn’t kept up with demand, and most American consumers refuse to entertain attitudes toward conserving energy that the rest of the developed world has already embraced?

For the record, most domestic U.S. oil costs more, not less, to produce than Saudi oil. Our oilfields are much more “mature” — which is another way of saying the easy (i.e. cheap) oil has all been pumped. Much of the new oil produced in the U.S. is coming from costly drilling operations in very deep water offshore in the Gulf of Mexico.

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