In Economics 101, a student learns that prices in the free market are set according to two main forces:  supply and demand.  When demand rises relative to supply, or when supply shrinks relative to demand, prices increase; when the opposite situation occurs, prices decrease.  The government can interfere with the pricing by setting a maximum price, which would tend to produce shortages, or by setting a minimum price, which would tend to produce surpluses.  The government can also artificially raise prices through taxation.

A textbook study in supply and demand was on display before Congress earlier this week, as executives from so-called "Big Oil" were brought before "Big Government" to explain their "excessive" profits.  Massachusetts Democratic Representative Ed Markey, chairman of the House Select Committee on Energy Independence and Global Warming, castigated the executives not only for the size of their profits, but also for not spending "enough" on alternative energy sources -- Markey, apparently an expert on how much and in what areas businesses should invest, believes the companies "should" invest at least 10% of their profits on petroleum alternatives.  Democratic Representative Emanuel Cleaver of Missouri tried to tie current consumer frustration with high gasoline prices to the 2005 retirement of former ExxonMobil CEO Lee Raymond, and his famous $400 million retirement package, ignoring, of course, that the retirement package was largely in ExxonMobil stock -- stock that greatly increased in value due to Raymond's successful management of the company.

Missing from Congress's inquisition was a simple understanding of Economics 101 that explains the high cost of gasoline:  demand is increasing relative to supply.  As economies grow, they consume more energy, and China and India, along with other economies around the world, are growing with extreme rapidity.  In 2006 alone, China added the equivalent energy consumption to that of the entire country of France; as it continues to grow, so does the demand.  That demand, along with increased demand in the US as well, drives up the price of petroleum, which of course drives up the price of products made from petroleum, such as gasoline.

But getting the oil is only part of the equation:  crude oil must be processed and refined to produce gasoline.  It is a costly, energy-intensive endeavor and requires specialized processes and facilities to do so:  refineries.  Capacity is limited at these refineries, just as with any other manufacturing or production facility, and the capacity of American refineries is insufficient to meet American demand for gasoline.  The result is that we now have to import not only the crude oil, but also gasoline itself.

So while demand is rising, the supply of crude oil and refined gasoline is not rising to meet it, thus causing an increase in prices, a concept apparently beyond the comprehension of Reps. Markey, Cleaver, and other anti-capitalist forces in government and elsewhere.  Their answer is neither to reduce demand nor increase supply.  Rather, the focus of the House Select Committee, as well as advocated by other Democrats (and some Republicans) in the House and Senate (including the Democratic senators currently seeking the Presidency) is to raise taxes on oil companies and "encourage" more spending on alternative energy.  Raising taxes on a business to encourage lower prices is somewhat analogous to beating a child to encourage him to stop crying:  it violates common sense and the laws of behavior.  The advocacy of tax-raising isn't confined to the evil oil companies:  Democratic Representative John Dingell of Michigan has proposed an additional $0.50 per gallon tax on gasoline (in addition to the 18.4 cent federal tax already in effect).

In the discussion about "excessive" profits, one might be curious to know the definition of exactly what point at which profits become "excessive' or "obscene".  The oil company profit margin is reported at 8.3 cents per dollar of sales.  Using that ratio, the sale of each $3.24 gallon of gas (the price I paid earlier today) nets the respective oil company approximately $0.27 in profit.  The federal government, as mentioned above, charges 18.4 cents for each gallon, so the oil company is making approximately $0.09 per gallon more than the federal government; of course, each state adds on their own gasoline tax, ranging from 7.5 cents per gallon in Georgia (plus a 4% sales tax) to 32.1 cents per gallon in Wisconsin; thus, in every state, the government makes more "profit" off each gallon of gas than does ExxonMobil, ConocoPhillips, Chevron, etc. -- without assuming any of the risk of running a company.

Another way of looking at the energy sector profits is to compare them to other industries.  Looking at the 2007 Fortune 500 list, ExxonMobil made $39.5 billion in profits on $347 billion in sales -- a margin of 11.4%.  Walmart, the top company in terms of sales, by contrast only had a profit margin of 3.2%; however, this doesn't seem to surprising, since Walmart deals in volume, not markup.  Some other top companies:  General Electric, 12.4%; Citigroup, 14.7%; Bank of America, 18.1%; Berkshire Hathaway, 11.2%; IBM, 10.4%; Verizon Communications, 6.6%; State Farm Insurance, 8.8%.  Decide for yourself whether or not ExxonMobil's profit margin is excessive when compared to other top companies.

But there's more involved as well.  To refine petroleum, one has to have petroleum, and the so-called "Big Oil" companies actually control very little of it:  approximately 80% of the world's known oil reserves belong to nationalized oil companies, such as Saudi Arabia, Venezuela, Iran, etc.  These countries form a cartel, OPEC, which controls the amount of petroleum allowed on the market.  Having complete control over 80% of a valuable commodity would seem to be a valuable position.  Add to the fact that much of that oil is in a very unstable part of the world, and that only serves to increase the "risk premium" on a barrel of oil.

So how can we lower gasoline prices?  As shown above, taking the entire oil company profit away would still mean gasoline costs $3 per gallon, and of course if the companies made no profit, they would provide no gasoline.  Taking away the tax bit would help a bit more, especially in states like Wisconsin, New York, and Montana, but still we're talking about pretty expensive gasoline, and governments typically aren't keen on reducing their income.  So, we are led back to Economics 101:  we can either reduce demand, and/or we can increase supply.

Increasing the supply of crude oil would start with areas where we know we have oil reserves but are barred by the government from obtaining the oil we know is there:  the Outer Continental Shelf, Alaska (within the Alaska National Wildlife Preserve), and areas of the Gulf of Mexico off the coast of Florida.  There are political obstacles to each of those locations.  But even were we to get more crude oil, we still don't have additional capacity to refine it; thus, we need to build more refining capacity.  It has been 30 years since a brand-new refinery has been built in the United States, but refineries all across the country are scrambling to add capacity.  The Motiva Refinery in Port Arthur, TX is embarking on a $7 billion expansion that will make it the largest refinery in the United States.  The high price of gasoline is obviously the motivating factor in that expansion, but there's risk involved -- what happens if the price of gasoline for some reason goes down?  Another often un-noted fact:  to make those "excessive" profits, oil companies deal with "excessive" risks.  Again, there are political obstacles to increasing refining capacity:  permits are required from the government, environmental regulations can be cumbersome, and people don't typically like to live near refineries.

The 2008 election can potentially have a huge impact on gasoline prices.  Both Democratic presidential contenders are promising a precipitous pull out of troops from the Middle East, specifically Iraq.  As mentioned above, there is already a "risk premium" being paid on oil due to Middle East instability; if there are insufficient US troops in the area, al Qaeda and Iran will have free reign to wreak havoc on the oil market, potentially greatly increasing the price of petroleum.  Oil at $100 per barrel could eventually seem like a bargain.

Ultimately, regardless of their efforts, outrage, and pious proclamations, there are only three ways to reduce the price of oil:  reduce government intrusion into the free market (via taxation and regulation), increase supply, or reduce demand.  The growing world economy and lack of credible alternatives in the near future seem to preclude a reduction in demand.