Friday, January 19, 2007

Gas prices will change - so who's at fault?

There was a post on gas prices at AllFinancialMatters that I thought was typical of the lack of knowledge about Economics that exists in our society. JLP cited a simplistic article (written by a journalist likely not trained in economics) and then presented some anecdotal evidence about milk prices to confirm the journalists mis-information.

I saw something I thought humorous about oil companies and pricing (sorry can't find the link):
  • when gas prices are going up oil companies are "price gouging"
  • when gas prices are going down oil companies are using "price dumping"
  • when prices stay the same oil companies are guilty of "collusion"

No matter what, "big oil" is always doing something wrong - taking advantage of the "little guy". People, (especially politicians) who engage in any of this useless rhetoric either don't know what they are talking about or are deliberately distorting knowledge to advance their own interests.

Oil and gas prices change in response to the laws of supply and demand - period. Oil and gas are commodities and fixing the prices of these items is very difficult to do. Prices have little to do with the cost of what it takes to pump or refine oil. So, if the supply of oil is reduced (by OPEC or hurricanes) then the price will go up. If the world economy is booming, demand increases and prices go up. And the converse is also true (which I believe is happening now - the Saudis are pumping more oil and the world usage is slowing a bit).

There is another factor in pricing that few people understand when it comes to commodities - the Commodity Futures market. The Futures markets were created to help business people reduce risk. For example, farmers planting corn in the fall could hedge their risk by purchasing futures contracts of corn. That way, if the price of corn fell drastically at harvest time, they wouldn't be wiped out. Of course, if the price increased drastically, they would lose that profit opportunity.

Futures markets are the most efficient system in Capitalism. They reflect nearly instantaneously the market price for a commodity. They greatly reduce short term price fluctuations, but they are not perfect. Speculators in futures markets can also create demand and drive up prices in the short term by bidding up futures contracts prices. This is what happened this past summer. Fear over oil shortages due to demand increases, hurricane forecasts and war fueled speculation that the price of oil would keep going up. However, as I discussed in my post on Straight Line Projections -things rarely continue in a straight line. Markets correct themselves. If prices are too high, people and companies reduce their purchases (price elasticity) and drive prices back down.

So when oil prices are increasing we see nearly instantaneous increases at the gas pump (now there is some de-linkage as gas futures and oil futures are different - if refining capacity can't keep up with demand, even falling oil prices won't necessarily drop gas prices). But why doesn't it seem that gas prices fall as rapidly as oil prices? Like most people, futures traders are reluctant to sell their contracts at a loss, so they tend to hang on a little longer than they should (who hasn't done this with a stock that's falling in price). But, in fact, once traders realize the bottom has fallen out of the market they dump their contracts and prices fall rapidly. This, in fact, happened just ten years ago when oil prices dropped to $12 a barrel.

Now the next time you accuse the oil companies of "price gouging" think about this. If buy your house and two years later due to market conditions, it is worth $50k more, will you still sell it at your purchase price? If not, you are just like every one else and no different than Big Oil.


JLP said...

I thought the article I referred to did a decent job of explaining the situation.

I agree with you that people tend to blame the oil companies no matter what they do. However, when it comes to gas stations, I think they raise prices as quickly as they can and drop them as slowly as they can. It's human nature.



Paul said...

If all economic activity is simply "human nature" than you are right. But the explanation is simplistic in nature and adds nothing to knowledge about the world, instead leaving the impression that greed is the driver.

gordan_horbec said...

I have been reading your blog for 2 hours. Great stuff here. To bad there are not more comments :(
Keep up the excellent work.

Paul said...

Please read my post on Spending Money and look at the recommended reading list. Studying Economics is extremely helpful in understanding what is happening rather than assigning blame for high prices.