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  • It’s Called Replacement Pricing, D*mmit!

    Posted by Shannon Love on September 13th, 2008 (All posts by )

    This really chaps my hide.

    I’m watching news stories about hurricane Ike and the subsequent rise in gas prices in parts of the country far distant from the storms. Reporters and politicians mumbled confusedly about how prices could be going up already.

    I’ll say it one more time for those who can’t be bothered to actually ask someone who owns a gas station. Gas stations set prices for the gas they sell today based on the wholesale price of the gas they will have to buy to replace it. Get it? The price you pay for a gallon today is the cost of the gallon the station will have buy to replace the one you just bought. 

    Gas stations sell gas at or near cost, so if they did not use replacement pricing any sudden spike in gas prices would shut them down and you couldn’t get any gas. I simply do not know why our public and private talking heads cannot understand and communicate this simple fact. 

    [update (9.13.2008.9:55am): More on gas pricing via Instapundit]

     

    18 Responses to “It’s Called Replacement Pricing, D*mmit!”

    1. Brian Says:

      It’s called Mainstream Media D*mmit! You are working under the false assumption that they care to understand. Untrue. They just want to take swipes at Business, Oil, and, as Mitch McConnell’s opponent calls them, “the Wall Street Fat Cats.”

      They don’t care about supply and demand. They reported this week’s OPEC announcement of scaling back production as if it were an isolated, minor event that will have no repercussions. When gas prices go up it becomes a convenient occasion to peddle “price-gouging” as part of a mythical, ongoing “war on the middle class.”

      Sadly, people bite.

    2. Tatyana Says:

      Shannon, explain to me, please: if the gas station sell the gas at or close to the prices they themselves buy it for, how do they make their profit?

    3. Shannon Love Says:

      Tatyana,

      Shannon, explain to me, please: if the gas station sell the gas at or close to the prices they themselves buy it for, how do they make their profit?

      Most gas stations today operate on the convenience store model. They lure people in with gas sold at cost and then make their profit on items those people buy in the store. This is why you don’t really see less expensive gas than at a convenience store.

      The counterintuitive part of this is that gas retailers hate high prices and sudden spikes because people have to spend money on gas and don’t buy the profitable items in the store.

      Even if a station does sell gas for profit, it must still use replacement pricing because they otherwise they don’t have a source of capital to purchase new gas. Gas sold today must pay for gas they purchase tomorrow. They have to use replacement pricing or sudden spikes in cost would destroy them.

    4. Tatyana Says:

      OK, so it’s like restaurants making their profit not on food, but on their wine list. Got it.
      Next question: how far ahead they (gas station owners) should guess the wholesale price of gas will be to cover sudden spikes? Example: I’m a gas station owner; today’s price is $3.50/ga. Am I estimating a spike in wholesale price tomorrow up to $4/ga or a subsequent fall, say, in a week from now, to $3.39/ga in deciding what to charge my customers today?

    5. Shannon Love Says:

      Tatyana,

      Next question: how far ahead they (gas station owners) should guess the wholesale price of gas will be to cover sudden spikes?

      Gas stations have only about 3-5 days of gas in their tanks when their tanks are full (at best, others refuel every day). So their time lines are very short. As a practical matter they will reflect wholesale price changes immediately i.e. within a day or even a few hours. From a personal observation I would say that family owned stations will shift prices quicker because they cannot get risk being caught upside down.

    6. Tatyana Says:

      But how they know about wholesale price changes of tomorrow and 3 days from now? It seems that today they start charging their customers the wholesale price they will have to pay once their tanks are empty, i.e. in 3-5 days (as you said their capacity is). So they are doing certain amount of prediction which might be wrong, either way, up or down.
      Or you’re saying they charge a replacement price as if they were buying the oil today, even if their tanks will not be emptied for another 4 days?

    7. Shannon Love Says:

      Tatyana,

      Or you’re saying they charge a replacement price as if they were buying the oil today, even if their tanks will not be emptied for another 4 days?

      Exactly. Remember that they my have to order fuel days in advance so its not so much a leap ahead you might think. Moreover, most will have existing contracts to purchase a minimum amount of fuel over a given time so they have to plan to pay for that as well.

      Every time we have some problem with gasoline supply people scream about gouging and politicians pledge to punish (and boy would they ever like to) yet you never see more than a couple of dozen prosecutions in the entire country. The simple truth is that market forces, which fuel suppliers are powerless to control, cause the sudden rises.

      As Rich pointed out in the link above, without this mechanism, gas would be sucked out of system during shortages because people would have no incentive not to buy as much or more gas than normal. Price rationing is the only way to suppress use when supplies are short.

    8. Youngblood Says:

      It’s called record profits, d*mmit!

      Back at the beginning of the year, Chevron posted record profits for the fourth consecutive year. Exxon-Mobil posted record profits — not just in relation to the company’s own profits, but in relation to the profits of every oil company, and every other American firm *in history*.

      They weren’t alone. During an economic downturn, oil companies were raising prices and posting record profits. While average Americans tightened their belts, oil company CEOs were, on average, making three times as much as the CEOs of other major firms. And, at the same time, they were enjoying massive subsidies at the expense of taxpayers, and massive royalty waivers conceived during a time of cheap energy.

      In other words, the oil companies aren’t merely hitting Americans at the pump, they’re hitting them at tax time, too.

      This is the political and economic climate that we find ourselves in today. It’s unfortunate that family-owned gas stations will face a lot of the animosity here, but the real question is why the oil companies aren’t willing to take some of the hit during a time of crisis.

      Meanwhile, as I said in the comments on another blog, Coast Guard personnel will soon be going into fairly dangerous conditions to rescue their fellow Americans, the families of emergency workers will do without seeing their loved ones, and many Americans will tighten their belts even further than they have to in order to donate goods and money to the relief effort.

      Meanwhile the oil companies will insist that they’re the victims of impersonal market forces, that this is just the invisible hand at work. And they’ll probably lobby for very visible handouts at taxpayer expense. They won’t open up their reserves to help get the nation over this temporary crisis. They will display the unique lack of compassion and unity that they have become renowned for and, come first quarter 2009, they’ll all post record profits for the fourth or fifth consecutive year, and their CEOs will continue to make several times more money than the CEOs of other corporations.

      Americans will continue to complain about this, and politicians will capitalize on that. This may even result in significant policy changes.

      That’s not to say that the oil companies don’t have a right to make money, or that they should become some kind of nationalized public service. However, a lot of Americans believe that, in times of crisis, Americans should pull together. Oil companies, even American oil companies, don’t seem to share that same belief. As long as oil companies create bad press for themselves, they will have no one to blame but themselves if Americans see them as essentially predatory.

      It sucks that family-owned gas stations are caught in the middle here, but it’s not really about them. It’s about the *fact* that consumer price increases at the pump have outpaced the price of crude oil. It’s about the fact that these increases have created record profits for the oil companies. It’s about the fact that Americans, even those who strongly support the free market, are growing tired of this state of affairs.

    9. steveH Says:

      Back at the beginning of the year, Chevron posted record profits for the fourth consecutive year. Exxon-Mobil posted record profits — not just in relation to the company’s own profits, but in relation to the profits of every oil company, and every other American firm *in history*.

      You’ve gotten wound up over a literally pointless number.

      The raw value of the profit amount doesn’t tell us anything, if we can’t compare it with the total cost of their doing business. If their profits have gone up tenfold, but the cost of doing business has risen faster, then they’re doing worse, in spite of having “record profits”.

      The energy companies’ profit margins have been running roughly 10%, more or less, which is in line for most successful companies in industry. The reason that the profit amounts are so big is because their total cost of operations is gargantuan.

      Those profit, meanwhile, don’t just pour into some bunch of fatcat’s pockets; the funds are needed to pay for future work; developing/maintaining/operating existing fields, developing new fields, funding future operations, etc.

    10. Ben White Says:

      This message doesn’t get out because of simple bigotry. We have one political party in the US that consistently foments bigotry, envy, and greed as a route to power. They want you to hate … oil companies today, tobacco companies yesterday, drug companies tomorrow.

      If you listen to their speeches, they always say they are “fighting for you”. They are fighting other Americans for you to get a benefit that you have not earned. They need you to give them power to fight. It’s OK to fight other Americans if you hate them. And here’s why you should hate them.

      That is essentially their message and the media are their spokesmen.

      Mistrust, envy, fear and hatred are common human traits. They are easy to exploit. It’s hard to gain a person’s trust if he has decided you are his enemy. He will not listen to you — he thinks you are probably trying to trick him. Your arguments seem to make sense, but that’s how you trick people: with arguments that seem to make sense. So even the flimsiest counterpoint reinforces the message of bigotry. You almost tricked him, but he was too smart to fall for it.

      We hate oil companies. We are smart. They make more money than us and we envy them. We are greedy so we want more and we want to give them less. They are run by people who are not like us. They are trying to trick us into paying more, and they always seem to get away with it.

      An intellectual argument is only going to work on a few people. An emotional argument will work on more.

      Do not rely on facts in your arguments to most people. Facts are of little use because facts are often wrong, edited, misunderstood, or simply made up.

      I suggest the only way this phenomenon can be turned around is to understand the root of the problem as I’ve described above. Then make a moral and spiritual argument against the bigotry and hatred and envy. People secretly know themselves. They want to think they are good and may hear you if you tell them to stop being bigots — to stop using hatred and envy to motivate their thoughts and deeds. They may listen to an intellectual argument at that time, so make it good and know your audience.

      You will never reach the ones seeking power. They know what they are doing. They foment bigotry on purpose. They are just playing a part and the things they say are a mere performance.

      You will also never reach some of the people who don’t care about right and wrong. Telling them it’s wrong to use hatred and envy won’t make sense. Why would they stop when it’s working so well?

      Now you know.

    11. Youngblood Says:

      SteveH wrote:

      “The energy companies’ profit margins have been running roughly 10%, more or less, which is in line for most successful companies in industry. The reason that the profit amounts are so big is because their total cost of operations is gargantuan.”

      Exxon-Mobil’s figures disagree with you here, as the company’s profit margin has doubled since 1998. The margin’s 10% now, but it was a little under 5% in 1998. This trend is fairly similar to the trend in the rest of the industry.

    12. Shannon Love Says:

      Youngblood,

      It works like this: You have a company whose cost is $10 per unit and put a 10% margin to sell the product for $11. Then the cost go up to $20 per unit so their standard 10% margin now net $2. Look, record profits!

      Of course, when the opposite happnes the companies profits tank just like they have done time and time again in oil industry. I certainly didn’t hear anyone like you offering to help the devestated oil industry during ’83-’88 oil crash.

      Perhaps you could explain, using numbers, exactly what the oil companies profits should be in you “just” fantasy world? What equation should companies use to determine when their profits are excessive or exploitive?

      And I want numbers, not vauge words like, “fair”, “resonable” etc.

      Perhaps you can explain the formula you use to prevent your own company from raking in “excessive” profits.

      In numbers please.

    13. Roy Lofquist Says:

      Dear Shannon,

      Either you’re extremely well informed or you owned a gas station at one time. My father did. My mother did the books. I worked at it before and after school and full time in the summer from the age of ten until I went into the Army.

      The business model has changed. In my day you were lucky if the gas covered the rent. Any money you made came from TBA and the lube bay. TBA is tires, batteries and accessories.

      Those went away with the appearance of specialty store to supply them. That’s why they’re now convenience stores. The convenience is for them. They depend upon impulse buying of things with immediate utility. They don’t make any money on cigarettes. They have enormous profit margins on water, soft drinks, candy, snacks and the like.

      It’s a tough business. You work long and hard with little security to make about a much as a truck driver. But you’re the boss.

      We’ve seen a massive move toward the proprietors being from the Indian Subcontinent. They have family financial networks to provide the startup capital and they’re doing it for their children.

      Sort of like the way it was when I was a kid.

      Regards,
      Roy

    14. axel hose Says:

      Your replacement pricing theory is so much BS. Yes the gas staions raise their prices quickly as the price of wholesale gas goes up but even the dumbest person knows what they do as wholesale prices come down. They drag their feet on price reductions until the cheaper gas staions lower their prices enough to make their overpricing unsustainable.

    15. Roy Lofquist Says:

      Dear Mr. Hose,

      You should read the thread before you blather. The price of gas is what brings in people to your profit center. If you are two cents higher than the guy down the street your customers go there.

      The most dreaded thing in the gas station business is a price war. Somebody starts selling below cost to steal your business and all the stations in the neighborhood are forced to match his price. Everybody suffers.

      The same thing applies to supermarkets. Many of the most popular items are sold at or below cost. This brings in the crowds so that they can sell the high margin items. The supermarket industry typically shows a very low profit on sales – typically in the 2% to 5% range.

      Please get a little bit more familiar with the territory before you start hurling insults at people. Do that under your real name and you will find yourself quite unpopular.

      Regards,
      Roy

    16. Shannon Love Says:

      Axel Hose,

      Yes the gas staions raise their prices quickly as the price of wholesale gas goes up but even the dumbest person knows what they do as wholesale prices come down. They drag their feet on price reductions until the cheaper gas staions lower their prices enough to make their overpricing unsustainable.

      No that just what you think happens because you don’t take into account high price pressure of a competitive market. Gas prices come down almost as fast as they go up.

      Do they drop prices slightly slower than they raise them? Most likely. I would in their shoes where guessing wrong puts one seriously in the hole. After all, are not you personally more likely to raise prices than lower them on the products you sell?

    17. Obloodyhell Says:

      > I simply do not know why our public and private talking heads cannot understand and communicate this simple fact

      The left plays on it, and the right doesn’t get the airtime.

      You hear enough about it on the Misean and Monetarist economics blogs, and a lot of non-lefty poliblogs.

    18. Obloodyhell Says:

      > We hate oil companies. We are smart. They make more money than us and we envy them.

      No, it’s not just that — we’ve had a couple generations, now, of training in hating them from childhood.

      Otherwise, why don’t we complain about ag prices and windfall profits??
      Corn is up 162% from two years ago. Soybeans 153%. Wheat 92%.
      Oil is only up 59%.
      If you think that the various ag people aren’t making beaucoup bucks, you’re snorting crack.
      But no one screams about the windfall profits derived from the cornfields in Iowa, or the soybean fields of Pennsylvania. No, they scream about oil!

      Since the 1960s, people have developed an almost Pavlovian response to the oil business, which, along with the utility corps, have become the Big Bad Wolf of industry. EVERY business gets carped at once in a while, but NO ONE ever has a good word for the oil industry or the utilities.

      You think they had anything positive to note back in 2000, when gas was a dollar a gallon (In constant dollars, the lowest price ever) and the oil producers were losing their shirts?

      HA!