Monday, May 9, 2011

Why You Are Paying So Much for Gas

Why You Are Paying So Much for Gas

And I promise I’m not going to say, “It’s supply and demand.” I cringe every time I hear one of my colleagues say that on the news. I’ll let you in on a secret: that’s economist code for, “I’m not really sure but I don’t want you to know that!” But, in reality, it’s a very simple story. Today’s spike is being driven by speculation, just as it was up to the financial crisis.
Don’t take my word for it. Consider the data. First of all, what those saying “It’s supply and demand” presumably mean is that prices are being determined solely by producers and end users. In other words, if what you pay at the pump is rising, it’s either because you and the rest of the community of gas-users are using more, or those who pump it out of the ground are finding less. Demand is rising, supply is falling, or some combination thereof. Let’s think about that. Here are weekly US gas prices since 1990 (data are from
US Gas Prices
[NOTE: If you can't see the graph clearly, right click on it and select view image and you'll see a larger version.]
Note that these are not inflation adjusted, so some upward slope would be expected just because of the slow rise in prices. Inflation from 1990 through 2010 was around 2.7%. The first full year of data is 1991, when gas prices averaged $1.10/gallon. Had they risen by 2.7%/year, they would be $1.87 today. I don’t know if you’ve filled up lately, but they’re a little higher than that!
However, out of respect for my colleagues, this doesn’t mean that the real key isn’t simply fundamental supply and demand. So, let’s break it down. With respect to supply, here, according to the US Energy Information Administration, are known world oil reserves since 1991:
World Oil Reserves
The only apparent correlation with the gas-price chart is that it is the opposite of what we’d expect! Of course, this is oil in the ground and not what was pumped out, but even with that caveat it’s hard to imagine that supply, alone, is responsible for a doubling in prices over a mere 26 months. Double.
Now demand. This would be highly correlated with world growth. Here are those data (inflation-adjusted annual GDP growth from the US Department of Agriculture’s Economic Research Service) from 1991 through 2010:
World Growth
Again, it is difficult to reconcile this with gas prices. While there as clearly been a huge jump in growth from 2009 to 2010 and this does coincide with a rise on the gas-price chart, compare this with what happened from 1991 to 1999 (even 2002, save for a brief spike). Supply, according to world reserves, changed only slightly, but there was strong and consistent world growth year in and year out. If ever there was a time we should have seen a huge rise in prices, it was then. Instead, prices bounced around between $1.40 and $1.00. Today, not only have known reserves risen substantially, but we are only just emerging from the worst recession since the Great Depression–hardly a boom period. For comparison, world growth averaged 2.6% from 1991 through 2002. Since then, it’s also been 2.6%, and over 2008-2010, it was 1.1%. This is not sounding like “It was supply and demand.” Is it surprising that gas prices are rising? No, not at all. The economy is recovering (albeit not nearly enough given our 13.5 million unemployed, but that’s another story) and there is considerable tension in the Middle East. But, do underlying forces justify an increase in pump prices from $1.81 in February 2009 to $3.81 as of yesterday? Absolutely, positively not. Nor was there a reason for the run from $1.07 in December 2001 to $4.00 in July 2008.
What’s left out of the equation is the financialization of the US. Our economy has become increasingly oriented toward managing financial wealth as opposed to the production of commodities. This started in the 1980s, with encouragement from both (I’m embarrassed to say) the economics discipline and the government. The former gave their scholarly blessing by telling everyone that markets were rational and efficient and the latter responded with deregulation of the financial industry and an increasingly hands-off approach to economic policy. Financialization both contributed to and was in turn encouraged by the massive run up of the stock market in the 1990s–the so-called “new” economy. Billions, nay, trillions, of dollars rushed around in search of easy money in the form of inflation-adjusted rates of return that simply could not logically be sustained (real GDP only rises around 3.5%/year, setting the upper limit to how much more prosperity we, as a nation, can truly enjoy). Look at the chart below showing the volume of activity for the S&P 500 since 1970 (
S&P Volume
[NOTE: If you can't see the graph clearly, right click on it and select view image and you'll see a larger version.]
Note the jump in the mid 1980s, followed by a gradually and then steeply increasing slope, right up to the financial crisis. Even after that, the level of activity is massive compared to the early part of the chart. This is a result of the massive amounts of money out there looking to make even more money; more, in fact, than is logically possible. And as standard opportunities have dried up, they have looked elsewhere: commodities and oil.
Properly structured, there is nothing wrong with speculation. When an airline buys fuel for delivery in the future, that helps them plan and provides an important signal to both consumers and suppliers. It creates helpful information. But now imagine that some portion of the trillions of speculative dollars created by financialization made its way into the oil futures market, looking for a quick buck. It seems like a logical thing to do: we all need oil and the prices are likely to go up, right? And note that these don’t have to be bad people. They are the ones in charge of your investment portfolios and retirement funds. They are paid by you to search for higher returns. But, what happens when they venture out of stocks and real estate and start buying oil futures (this was, incidentally, encouraged by the deregulation of the commodities market in 2000–note the increase in volatility of gas prices after that)? It’s simple: the increase in demand causes futures prices rise. And as futures prices rise, those pumping oil out of the ground today decide to save it for tomorrow since “the market” says that price will be higher then. This has the effect of lowering today’s supply and raising today’s price. Having observed this, speculators say, “Hooray! We were right! Let’s buy some more!!!” And so the cycle continues, driving up oil prices and causing gas to–-for no logical, underlying economic reason–-jump from $1.81 in February 2009 to $3.81 in April 2011. Unlike someone playing the roulette table in Vegas, this has tremendous negative consequences for the rest of the macroeconomy and has the power to start a new round of 1970s-like inflation. Let’s not.
There are many authors who have gone into much more detail on this issue than me. Rather than repeat all their work, I’ll link a couple of the best ones below:
Paul Davidson, economist and editor of the Journal of Post Keynesian Economics
Mike Norman, Chief Economist, John Thomas Financial
Payam Sharifi, economics PhD student at the University of Missouri, Kansas City
Michael W. Masters, Portfolio Manager for Masters Capital Management and Adam K. White, CFA, Director of Research for White Knight Research & Trading
Joshua M. Clark, Senior Writer for How Stuff Works
In closing, let me say that I have nothing against high gas prices, per se. The sooner we develop alternative energies, the better, and as today’s prices rise so the incentive to do so increases. But, we can still do that with cheaper gas. There is no reason it should be any higher right now than, say, $2.00 to $2.50/gallon. And even if we put a research tax on top of that of (for example) $0.50 to generate grant money for universities to use in developing alternatives, we’re still at only $2.50 to $3.00/gallon, PLUS we would be simultaneously working pro-actively to create a solution for future generations.
As for me, I’ve got no desire to pay double at the pump for the sake of my and other’s retirement portfolios, especially since the latter will soon enough be seriously damaged by the effect of rising commodity prices on the non-financial part of the economy.


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