The Rules of Supply and Demand Apply to Gasoline, Too

Posted by PITHOCRATES - October 18th, 2010

What’s the Difference Between Underwear and Gasoline?

Go through your wife’s or girlfriend’s underwear drawer.  What do you see?  What kind of underwear does she have?  Silk?  Nylon?  Satin?  Cotton?  Chances are you’re not going to see only one type.  There’ll be a little variety.  If you don’t see her get dressed, can you tell what she’s wearing?  Probably not.  The underwear she’s wearing will have no impact on her life.  Whatever she does on any given day will probably be the same regardless of her choice of underwear on that day.

All right, now think about what kind of fuel she puts into her car.  What are her choices?  At best, maybe two.  Far fewer than her underwear choices.  Chances are that she’ll be running her car on gasoline.  If it’s a late model car and she’s a hardcore environmentalist she may be using E85 (an alcohol-based fuel made from food).  However, if she finds herself having to refuel in a bad part of town late at night she’ll probably be switching back to gasoline pretty darn quick.  You see, you just can’t drive as far on a tank of E85 as you can on gasoline.  For when it comes to fuel, gasoline is king.  It packs a lot of energy per gallon.  It’ll let most people refuel on the weekend at that safe gas station close to home.

So what’s the difference between underwear and gasoline?  Choice.  If the price of gasoline goes up, we have but two choices.  Pay more.  Or drive less.  If the price of cotton goes up, we can pay more or wear less cotton.  And when there’s other fabric available (silk, nylon, satin, etc.), wearing less cotton is a whole lot easier.  And that choice will never put anyone in danger.  Like stopping to refuel in a bad part of town late at night.

Market Forces Driving Market Prices

Well, cotton prices are going up (see Flashback to 1870 as Cotton Hits Peak in the Wall Street Journal on line by Adam Cancryn and Carolyn Cui).  Floods in Pakistan and heavy rains in China have significantly reduced the supply of cotton.  And when supply goes down, what happens to prices?  They go up.  How much?

The sudden surge in prices—cotton has risen as much as 56% in three months—has alarmed manufacturers and retailers, who worry they may be forced to pass on higher costs to recession-weary consumers.

Ouch.  56%.  Even gasoline doesn’t go up that much in three months.  But will we, the consumers, absorb that increase? 

For the apparel industry, rising prices have upended roughly two decades of cheap cotton. Consumers have become used to relatively low prices, making it hard for garment producers to pass on the rising costs, especially as the economy struggles to recover.

Probably not.  Why?  Because we have fabric choices.  Wearing something other than cotton is no big deal.  It’s easy to do.  And life will go on just as it did when we were wearing cotton.  We won’t notice the difference.  Which is why it’s hard to pass these price increases on to us.  It’s not the same with gasoline.  With gasoline, we don’t have other choices.  Maybe E85.  But we’ll have to buy more of that to drive just as far so we might as well pay the higher gasoline prices.  At least our wife/girlfriend won’t have to stop to refuel in questionable parts of town.  But cotton isn’t gasoline.  People will buy other fabrics if cotton prices go up.  So manufacturers will look at ways to keep from passing on these costs

The most at risk are discount retailers that compete on price and sell large quantities of cotton-based basic items, such as T-shirts. But clothing manufacturers of all price levels may be forced to decide between absorbing the costs or passing them on. Some say they also are exploring different materials, including synthetic blends.

Because consumers have clothing choices, clothing manufacturers will switch to less expensive fabrics to offer what the consumer will choose.  Gasoline producers can’t do this.  There’s only gasoline.  Sure, there’s E85.  But E85 is not gasoline.  When you choose E85, you get less.  It’s not the same with fabric.  There may be a difference in the feel of cotton and a synthetic blend, but you’re not going to incur additional costs with a synthetic blend (i.e., you won’t have to buy more of the synthetic blend clothing for the same amount of ‘wear-time’ of the cotton).  So the consumer won’t just whistle a happy tune and pay these higher prices.   

Compounding this problem of supply pressure on prices is the demand pressure.

Meanwhile, demand from Chinese cotton mills has shown no signs of slowing. The U.S. Department of Agriculture said China bought 267,700 running bales of U.S. upland cotton last week, more than half of the total bales exported and more than the country usually takes.

The clothing manufacturers may be suffering, but, surely, the cotton farmers must be loving this.  Just like Big Oil must love those high oil prices, right?  Sure.  As long as someone is buying at these prices. 

However, the lofty prices are making some cotton farmers worry.

“I hope it won’t go too high. If you can’t put it into clothes and clothes become too expensive, prices will come down,” Mr. Wilkins said.

And that’s the problem.  As prices go up, we buy less.  When we have choices, we just won’t pay high prices.  And in free-market capitalism, there are always choices.

Drill Baby Drill – If You Want Affordable Gasoline

There are no other fuels to compete with gasoline like there is with fabrics.  But we still have a choice.  We just drive less.  That’s a choice.  Before the great recession resulting from the subprime mortgage crisis of 2008, gasoline had peaked around $4/gallon.  It doesn’t cost that much now.  Prices came down because a lot of people bought less $4/gallon gasoline than they did $2.75/gallon gasoline.  But that price will go up again.  Not because of Big Oil’s price fixing (if they could fix prices gasoline would not have come down from those $4/gallon prices).  But for the same reason cotton prices are going up.  Exploding demand in China. 

Until there is a viable alternative to gasoline, gasoline prices will always be more volatile than clothing prices.  But the laws of supply and demand will have similar affects on each.  A reduction in supply (a poor cotton harvest or a lack of new oil drilling) will raise prices.  An increase in demand (hungry Chinese cotton mills or a growing Chinese middle class buying and driving cars) will increase prices.  Both of these together will really increase prices.  It’s not Big Oil.  It’s not Big Cotton.  It’s simple economics.

How do you make these prices go down?  Well, with little control over the Chinese economy, our only choice is to increase supply.  And when it comes to gasoline, that means we need to drill more.  The more oil we pull from the ground the more we can refine.  It’s just simple economics.

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