This is a parable about a chicken farmer and an oilman.
People who should know better continue to blame the oil companies for high oil prices. There is still widespread confusion about how oil and gas are priced.
Furthermore, I find that many people believe that the fact that gasoline prices and oil company profits are at record highs means that oil companies are definitely gouging consumers. “Explain this!” they’ll say as they show me a link about Chevron’s CVX-2 percent profits (as if this revelation will finally make me see the light).
So I came up with a story to help readers understand.
Analogies are useful for breaking down complex topics into simple and relatable problems. An analogy is obviously not perfect, but its purpose is to increase understanding.
I shared the following story on Telegram earlier this week, and it was well-received. Some suggested that it be published in Medium, so here it is.
The Chicken Farmer
Assume you are a chicken farmer. Because you run a large operation, you don’t sell individual chickens to your neighbors. You take them to a market every week where they are auctioned off.
Chicken is sometimes in high demand. Perhaps there is a season when people eat more chicken. Because if everyone wants a chicken, the price people are willing to pay rises, and you make more money.
Sometimes supplies run out. Perhaps your neighboring chicken farmers have had bad luck with bird flu and have fewer chickens for sale. You make more money when supplies are scarce and demand is high.
There may be times when you make far more money than you spend on chickens. If you will, consider it a windfall. People become enraged when you make more money at their expense. They may demand that you reduce your price for your chickens, even if the price is set at auction.
Then there are times when there is a bumper crop of chickens but the public has decided to eat fish due to changing preferences. Some people may think that fish farmers are the key to the future.
You take your chickens to market, but you get far less than you paid for them. You suffer a significant financial loss. You decide to leave the chicken business if you lose too much money. This will have an impact on future chicken supplies. But, hey, as long as everyone is eating fish, there should be no problem, right?
In this process, who did you gouge? Sure, there were times when chicken prices were high and you made a lot of money at the expense of your neighbors.
But that’s because everyone in that chicken market was looking for chicken. They were bidding up to what they were willing to pay, not paying more because you decided to raise the price of chicken dramatically.
Of course, it’s even worse if they have no other options. But it’s not you, the chicken farmer, who is exploiting people. Those purchasing chicken may object to the manner in which it is sold.
Imagining a Different Model
Perhaps there is another way to sell chickens that will allow the farmer to profit while the customer pays a “fair” price. Assume you decide you don’t need to make as much money and decide to sell your chickens based on the cost of raising them.
Based on this model, I can predict two things.
First, there will be those who will purchase them only to resell them at the chicken auction. The profit margin based on supply and demand will shift from you to them.
Another way to consider this is to consider your home. Assume that prices in your neighborhood have skyrocketed. Instead of selling the $200,000 home you bought for $200,000 at market value — say, $600,000 — you decide you don’t need that much money. You’re happy to sell your house for $250,000.
Buyers will rush to your home, which is still valued at $600,000. You just gave away your home’s profit to someone else, who can buy it for $250,000 and sell it for $600,000.
Second, there will continue to be times when chicken prices fall. Neighbors who were willing to pay you a small profit margin for your chickens when market prices were high will be far less willing to pay you more if market prices fall.
When the price of chicken falls, they will buy it at the chicken market, forcing you to lower your prices. You will continue to lose money, but you will have less profit in subsequent years to offset those losses.
That is how crude oil is priced.
The COVID-19 pandemic disrupted supply chains for many of these commodities, resulting in a reduction in supply. That is the primary reason why the prices of many commodities skyrocketed, and it was a major factor in fueling inflation.
Yes, this results in huge profits for some of these companies, but there are times when prices fall in the opposite direction.
In my most recent Medium article, I mentioned that ExxonMobil (XOM-1.3 percent, NYSE: XOM) made $25.8 billion in the previous year. People are furious. However, the company lost $22.4 billion in 2020, and many smaller oil producers went bankrupt.
People who were outraged about their profits today didn’t care about all the bankruptcies in 2020. Those bankruptcies from 2020, however, contributed to today’s supply shortages.
We could change the price of oil and gas, but there would be consequences. For example, Venezuela keeps gasoline prices well below market value for its citizens. However, this has essentially destroyed the country’s oil industry.
Maybe there’s another way. It would also have to safeguard vital industries if prices fell. However, it is not as simple as saying, “Prices are high because companies are gouging us.” That is why appealing to oil companies’ “patriotic duty” to lower prices is illogical — because that is not how gasoline is priced.
