Gasoline Column - July 21, 2006

WORLD EVENTS AND CRUDE OIL PRICES: HOW THEY AFFECT WHAT YOU PAY AT THE PUMP

Current Gasoline Market Conditions

On July 17, the Energy Information Administration (EIA) reported that the national average retail price of regular gasoline was $2.99 per gallon, up 1.6¢ from the previous week. Consumers on the East Coast paid the biggest increase (1.8¢ per gallon), while consumers in the Rocky Mountain states paid the smallest increase (0.3¢ per gallon).

Crude Oil Prices and the “Risk Premium”

Crude oil is the major input into refined products – including gasoline – so it’s no surprise that higher crude oil prices mean higher prices at the gas pump. After climbing steadily for two years, the price of crude oil on world markets has surged in the past few months. Continued high demand for gasoline in the United States and increased demand in China, India, and other industrializing countries explain the price increases over time. But what’s behind the recent spike in crude oil prices?

It appears, in large part, the cause is world events: The fighting in Lebanon and Israel, which are located near the world’s richest oil-producing regions; insurgent attacks on oil facilities in Nigeria, which have reduced its crude oil production by 500,000 barrels per day; the conflicts over Iran’s nuclear program; and the uncertainty over Venezuela’s future oil supply are among the factors influencing current crude oil market prices.

And predictably, the major sellers of crude oil react to these events by demanding a premium for oil sold for future delivery.

Buying and selling oil for future delivery is an important part of how many industries conduct business. Much of the world’s easy-to-find, inexpensive-to-pump oil has already been found. Producers typically do not commit resources to finding and producing more expensive oil unless they know in advance the price they can get. Similarly, large users of gasoline and other refined products – say, airlines and trucking companies – need to lock in a price for their supply to avoid uncertain costs in the future.

Buyers and sellers on the oil futures market face financial risks. A firm selling a contract for future delivery of oil will lose money if the market price at delivery is higher than the contract price. And a buyer will lose money if the market price at delivery is lower than the price in the futures contract.

Savvy buyers and sellers forecast how close futures contract prices are likely to come to actual market prices at delivery. Among the factors they consider are the likelihood that world events will cause an oil supply disruption resulting in a price spike, how long the disruption might last, and how much oil output it might curtail. They know that even small supply disruptions can cause whopping price increases because the demand for oil and gasoline doesn’t change much in the short run in response to higher prices. It is no surprise that the events that have the greatest impact on future oil supply – and therefore on prices – are wars and natural disasters.

A seller in today’s oil futures market must estimate not only the likelihood that the current conflict in the Middle East will affect prices in the future, but also how great the impact might be. If there is a significant chance that prices in the future may be significantly higher due to market disruptions or other factors, a seller will demand some premium to cover these risks of selling the contract. Futures traders and economists call this a “risk premium.” At the same time, buyers must determine how much they’re willing to pay for insurance to assure future delivery. The actual risk premium is reflected in the futures contract prices, which are determined by the bargaining of sellers and buyers.

Effect on Consumer Prices

An oil producer can choose to sell its oil today or hold it for delivery under a futures contract. When futures contract prices increase by more than the producer’s holding cost, the producer will make more money storing the product.

Because building crude oil inventories may reduce the current supply of gasoline in relation to demand, today’s rising oil futures prices can translate into higher gasoline prices in the short-term. Looking forward, though, this means more crude oil supply will be available in the future, thereby reducing gasoline pump prices below the levels we otherwise would see.