Ironically, on April Fools Day Congress held hearings with the oil and gas industry over profits and government subsidies. The reported bantering between politicians and oil executives missed the complete point on the issue. Oil executives claim that their profits are in line with other industries and they have no influence of pricing and it is related to supply and demand and if we would just open ANWR and other known reserves all of our problems would be solved. Congress argued that they no longer needed the subsidies and they should spend their own profits on alternative resource development.

First, it is important to place the conversation in proper economic context. At the extremes, there are two approaches that companies take in making economic decisions (see graph). In a purely competitive environment, the business must take what price the market requires and will produce units up to the point where marginal cost and price are equal. The profit the company makes is based on the cost structure, but the emphasis is on reducing costs as they have no control over price (therefore called price taker). On the other extreme is the monopoly that can set the price at any level they want, although if the price is too high or low they will not generate any revenue (therefore called price searcher). They will choose a point where the additional cost of producing another unit equals the additional revenue from selling another unit, which maximizes profits. The goal of the monopoly is creating more demand so they can increase the price and profit. The oil and gas industry is concentrated into five multinational corporations and operates close to the monopoly model. The implication is that oil executives do influence price and profits, so for them to say it is simply a supply and demand problem is not entirely correct.

The first legitimate question that must be asked is whether having the oil and gas industry, which is so critical to our economy, is appropriate to have concentrated in five companies and operating as an effectual monopoly. A couple of decades ago, there was dozens of oil and gas companies and the market operated much closer to pure competition (or price taker). Oil and gas is a critical commodity and needs to operate in a more competitive environment. If Congress is serious about making changes, then breaking up the five companies and going back to a model with real competition should be on the table for discussion. The current model is in the best interest of the oil companies and their shareholders, but it is not in the best interest of consumers and in this situation the consumers should hold priority.

The oil executives suggest that increasing supply by opening up ANWR would bring down prices and help out consumers. This is a false argument that reduces their costs, but not consumers. Some day we will need to drill in ANWR and tap other reserves, but today we have enough available oil in the world to meet demand. Only a couple of years ago the complaint was that there was not enough refinery capacity and that was the bottleneck. More access to oil, without refinery capacity, does little to alleviate the problem. Again, however the argument is entirely off base. If we really want to solve the problems, the answer is not on the supply side, but is on the demand side. The question is how we make dramatic reductions in demand, which would do more to lower price than increasing supply. We can continue to hope that people drive less, and we do have some options to reduce gas consumption, but we do not have the flexibility to make radical changes in gas consumption through lifestyle changes. We do not have a mass transit system that works effectively, which would allow more people to drive less. We can convert to non gas alternatives, which is effective assuming we are not converting food into fuel. If we take agricultural land and require it to produce for both food and fuel we increase the demand for grain and will therefore increase the price of both food and fuel, an unwise government policy (biodiesel from substances that do not take away from the food supply is a legitimate strategy).

The only other viable option is to increase fuel efficiency through technological gains. If CAFE standards were doubled, the demand for gas would decrease radically and the price of gas would follow. The irony of the situation is the answer is not in the oil and gas industry, but is in the auto industry. The problem is the auto industry is struggling financially and cannot afford to do the research required. The oil and gas industry has the money for the research, but not the solutions. Congress is partially right; if we want to solve the problem we should pull the government subsidies from the oil and gas industry and move them to the auto industry to increase fuel efficiency, either through electric engines or radical improvements in gas mileage efficiency.

If Congress and the oil and gas industry are truly interested in reducing the cost of gas, the only viable answer is in demand reduction, not increases in supply. The only two demand reduction strategies that will have a meaningful impact over the long term are mass transit and fuel efficiency. The good news is both of those strategies not only improve the economic situation, but also help the environment as well.