Recently there was a bad fire at the Chevron refinery in Richmond, CA, as you probably know. The refinery will be offline for an unknown period, probably months. Upon reading this, and knowing that the CA government prohibits “imports” of gasoline from other states, I knew the retail price would jump. I made a mental note to fill up my Thunderbird next morning. Too late – regular had jumped from $3.85 to $4.01. This morning it was $4.06, and $4.13 by afternoon.

My reaction? I’m delighted that the market is doing its job of balancing supply, which has suddenly dropped, with demand. But predictably, ignorant fools have jumped on this situation, as in this letter in this morning’s San Francisco Chronicle:

Please ask Chevron to explain why the cost of gasoline will go up because of an accident at their plant. Don’t they have insurance to cover the loss of their equipment? Is Chevron going to recoup the lost income (deducted from the billions of dollars in profit that they make every year) from us? If the accident was determined to be due to Chevron’s negligence, are they going to compensate all of their neighbors “inconvenienced” by this? But most of all, please ask all the other oil companies why their costs are going up because of a fire at a Chevron refinery. If the other companies are not suffering a financial loss from this devastating environmental disaster in the Bay Area, why are prices expected to rise at Exxon-Mobil, Royal Shell Dutch, BP (Arco, lest anyone forget) and any other company I might be too angry to remember at this moment? I might have to hold my breath until you find out the answers to these questions or until the air clears, whichever comes first. I’ll let you guess which one that will be.

Chevron probably doesn’t carry insurance because they are big enough to be self-insured, and the risks may be too large and uncertain for an insurance company to estimate. But insurance is irrelevant to retail pricing. The basic problem is the all too common myth on which this letter is based: that cost determines price. The myth is that suppliers add up their costs and then tack on as much profit as they think they can get away with. As anyone who has studied economics should know, supply and demand jointly determine price in a competitive market such as gasoline. Set your price too high and you lose customers and your profit declines. Set it too low and your margin declines, and you may sell out your supplies. The sweet spot varies constantly with shifting supply and, to a lesser extent, shifting demand.

Of course, profits benefit Chevron’s shareholders. But they are vastly more valuable to Chevron’s customers because they are the driving force (putting aside government interference) that tells Chevron what kind of products we want, where they are offered, how they are delivered, etc.

Of course, government interference is substantial and shouldn’t be set aside. Politicians worried about rising gas prices could help out by lifting the prohibition on imports.

Hurray for profits!