Low-Energy Fridays: What’s the Effect of Making Profit Illegal?

In California, Gov. Gavin Newsom is taking a victory lap, exclaiming that he “took on Big Oil and won.” He’s talking about a new law that requires oil companies operating in California to report their profits to the state, and if they are deemed too large, the state will allow regulators to impose fines. The logic behind the legislation assumes that gas prices aren’t high because of scarcity, but because of the malicious intent of oil companies that engage in “price gouging.” If oil companies are in fact manipulating the market to force prices up, then California’s policy response could make sense. But if high prices are instead caused by market conditions, the new law will have the opposite effect, deterring exactly the sort of investment that is needed to bolster supply and reduce costs.

In a well-functioning market, the profits a company makes signals to potential competitors that there is money to be made if they can claim some market share for themselves. This competition then incentivizes firms to cut prices, lest they lose their customers to a lower-priced competitor. High profits for oil companies are hard to view as a good thing, but as the fracking boom demonstrated, it was exactly because prices were so high that production rose, and prices later fell.

Currently, high gasoline prices are explained by a few big factors. As the world has emerged from the pandemic, oil demand has risen and so have prices. The Organization of Petroleum Exporting Countries (OPEC) and Russia have been colluding to cut production and induce market scarcity (and this collusion is beyond California’s regulatory reach). In the United States, gasoline prices have been especially high due to a shortage of refining capacity, which will likely persist since many policymakers are pushing for reduced combustion engine vehicle usage. California itself has a ban on new combustion engine vehicle sales by 2035, which indicates to potential investors that the success of new refineries would be short-lived compared to typical refineries that stay in operation for decades.

These economic conditions better explain high gasoline prices than oil companies manipulating markets, but there is something of a siren’s call for politicians to pursue simpler rationale for market conditions they don’t like. We see this with politicians’ blaming high inflation on “greedy corporations” rather than their own pandemic-induced inflationary policies of high spending coupled with low interest rates. But importantly, when politicians get it wrong on the explanations for why prices are high and miss the mark on policy, consumers suffer, and California’s experiment on regulating profit is nothing new.

During the 1970s, the Arab members of OPEC embargoed exports to the United States, and at the time America was under price controls for oil. Trying to keep costs low, politicians capped prices, but this meant only producers who were profitable under those narrow conditions produced, and supply remained low and prices high. For a time, there was even rationing in place, and Americans had to wait in long lines to fill their tanks. Unsurprisingly, when price controls were lifted, supply increased and prices fell.

In California, this new law will function like the price caps of the 1970s. Market entrants will be deterred, forcing Californians to deal with scarcity, high costs or both. As much as policymakers might hate it, they would better serve their constituents by addressing the market conditions that cause high energy prices, rather than denying the simple truth that more people are buying oil products than the market can supply.