Fuel to the fire: The economics (and politics) of petroleum

Fuel to the fire: The economics (and politics) of petroleum

It’s Thursday; your salary has just hit your account and you’re cruising home after a hard day’s work when, suddenly, that dreadful light illuminates your dashboard. Frantically searching, you find that fuel prices are a full 15 cents higher than they were yesterday, with the price seemingly climbing the further out you go. You have 60km to perform your duty as an informed consumer and find the best bang for your buck at the bowser or die trying.

This is the predicament many of us have found ourselves in, but just what forces are at play in the seemingly cruel machinations of petrol prices?

Basic microeconomic theory would hold that as a good with comparatively inelastic demand, the price for petrol is irrelevant, so retailers have comparatively free reign – after all, you have to drive to work even if the world ends right?

Figure 1: Indexed petrol price vs consumption per capita. Consumption rates plateau by 1976, despite short term fluctuations and the long upwards trend in price, indicating inelasticity. Source (page 28).

But this isn’t the full picture – plenty of goods demonstrate price inelasticity, even ‘luxury’ goods like coffee, yet we don’t go to the café expecting to pay more or less on a given day of the week. As such, it is also necessary to delve deeper into market structure.

At first glance, practitioners of microeconomic theory would assume that retailers are slaves to international markets, barely eking out a living at the mercy of OPEC and exchange rates. Not so in this case. Thanks to our friends at the ACCC, we have a smoking gun:

“Price cycles are the result of deliberate pricing policies of petrol retailers, and are not directly related to changes in wholesale costs.”

– ACCC

How about that. But just what are these pricing policies?

From data in industrialised nations, we can say with confidence that petrol markets conform to the Edgeworth Price Cycle. A more detailed explanation can be found here, but in short it is a phenomenon where firms in a market for an identical good face extreme incentives to cut prices due to competition. Price spikes may occur, but over the long run there is downwards pressure on price until profit margins are again zero. A change in the wholesale price, usually the result of a supply shock or exchange rates, forces firms to hike prices again, beginning the cycle anew.

Figure 2: Time series of petrol prices in Perth across 2018. Note how periodic retail price spikes trend down to the wholesale price until another shock sets in, as per the Edgeworth Cycle. Source (page 386).

Firms may enjoy brief periods of higher margins following an oil shock, but the bite of competition makes them clever devils. To avoid this downward spiral, retailers can find clever ways to encourage consumer loyalty; ever wondered why you get cents off the litre at a supermarket’s subsidiary petrol provider? It’s to keep you coming back to the same pump rather than going to a cheaper competitor. Other factors also induce loyalty like location – it isn’t worth driving across town when you can fill a tank closer to home. This is also why we see heterogeneity in prices between regions, since factors like income (which dictates demand elasticity), local competition and even the day of the week also affect prices.

So here comes the big question; why is it that petrol can shoot up practically overnight, but take months to recover? Are retailers out to get us, conspiring to wring every last cent out of us at the bowser? Perhaps not – many economists maintain that asymmetric pricing, or the ‘rockets and feathers’ hypothesis, explains how rapid price increases followed by slow declines are a natural consequence of many commodity markets, rather than a result of collusion. When retail markets operate at zero profits, an increase in wholesale price is passed directly onto consumers. When the wholesale price falls, profit-making firms can then successively undercut each other, bringing the price down more slowly.

However, healthy suspicion never led anyone astray. Indeed, Valadkhani & Smyth allege that in Australia, there’s reason to believe firms are behaving opportunistically. Aware of regulator scrutiny, firms are willing to accept short term losses when oil prices rise in order to induce a disproportionate rise in price at a later date, simultaneously recouping their losses and confounding regulatory bodies. The ACCC has certainly observed the difficulties ensuring fair pricing behaviour and higher retailer profit margins in recent years, so perhaps there is stock in this claim.

Either way, the price you pay at the petrol station does not directly relate to trends in international markets, so it is important to make a habit of studying trends and familiarising yourself with the price cycles in your area.

With my remaining words, it’d be remiss not to mention the political implications of the petrol market. As a commodity that everyone must purchase, voters are naturally very sensitive to price fluctuations. Indeed, the 2022 federal budget has seen the fuel excised halved, despite mountains of post-Covid debt that the fiscally conservative LNP is no doubt eager to pay off. The extent to which retailers will pass this on to consumers however, and how regulatory bodies can guarantee this, remains to be seen.

Of course, on some level petrol prices are weaponised as bad faith, partisan attacks against incumbents. The reality is that governments don’t have much control over international trends and the actions of private firms. The best they can often do is offer support to those hit hardest.

However, while instrumentally true, this is unsatisfying. I would personally go further to suggest that government inaction is a distinctly ideological position, where governments are peons rather than stewards of the free market. Government intervention and tighter regulation, even at the expense of some efficiency can have net benefits for society as a whole in the form of security and certainty.

Going forward, the crises like the one we face now are at the very least mitigable. Stockpiling strategic reserves to cushion oil shocks, expanding regulatory oversight, transitioning away from fossil fuels and even nationalisation (yes, the n-word, stay tuned for a future article!) are some such measures. After all, it’s more than a weekly inconvenience – oil is tightly bound with food security and energy generation more broadly, if markets are failing us then we cannot afford to let the problem solve itself…


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