What this movie is really about
The storyline is similar to Ambrose Bierce's story "An Occurrence at Owl Creek Bridge", in which a prisoner is hanged, while imagining escaping and traveling home. Basically, as he's about to die he imagines in his mind this whole story that he escapes--leading us, the readers, to believe him--but then he starts having hallicinations and whatnot and we learn that he never actually escaped but that these were his dying thoughts.
The idea is similar to Lost Highway. The opening song explains it all. "I'm Deranged". Yes Fred is very deranged. He's a murderer and sick in the head. The entire movie takes place in Fred's mind as he sits on Death Row awaiting to die for murdering his wife. The first half of the movie he tries to remember what happened since he believes he's innocent. But the truth of what he did threatens to emerge, and these guilty thoughts take on the form of the video cassettes and finally the mystery man.
While sitting in jail he is unable to accept and come to terms with what he did and as his execution day approaches he creates a new reality in his mind and imagines himself as a completely different person, Pete, with his own life and his own past. He becomes Pete in his mind and begins living Pete's life (in reality he's probably just sitting in cell all quiet and staring like a mental patient at the wall) However again his past is coming to haunt him--his friends and family mention 'what happened that night' but never state what they are talking about ('that night' was the night he murdered his wife) and then he imagines Renee, only this time as a blond named Alice, who he wants to possess for himself. They become involved in a wild relationship that again ends in murder and when Alice tells him, "you'll never have me" she's reminding him of the truth. He never will have her, She's dead and that's that.
He changes back into Fred (all still in his mind, don't forget) and now we relive with him what happened with him before the events of the movie. In real life he followed his wife renee to the sleazy motel and caught her having sex with Dick Laurent. After she leaves Fred beats and Kidnaps Laurent and then kills him in the desert. He then goes home and at some point, probably after the Andy's party, kills his wife. In his mind though, as he relives this, rather then go in his home after killing dick laurent, he simply speaks into his intercom and says Dick Laurent is dead--the opening line of the movie. Then he sees the cops who are following him and a car chase begins. As he's speeding down the highway, in real life he's being lead to the electric chair by prison officials. When we see the lights begin to flash in the car and we see Fred's face twist, contort and start to smoke, thats because he's cooking in the electric chair. and as he dies, the highway runs on and on. Fred Madison was man lost in his mind and the title Lost Highway is a metaphor for that.