Noticed anything different at your local gas station lately? After a summer of sky-high gas prices, there’s been a dramatic and rapid decrease in the price at the pump. No complaints, right? But you do have to wonder, “What gives?”
There are many people willing to offer answers to that question; speculation is rampant in the news media and in daily conversation. Unfortunately, not all of it is equally enlightening, but armed with the tools of economic reasoning, you can sort it out.
Who or What Caused It?
Have gas prices really come down, or is it a case of “too good to be true”? The Washington Post reports that some Americans believe that falling gas prices are part of a political conspiracy.
Three out of 10 Americans think the recent fall in gasoline prices is a result of domestic political factors, including White House and Republican Party efforts to influence the November elections. That's nearly as many as the 35 percent who attribute the recent price decline to market forces or supply and demand, according to the poll of 1,204 adults conducted from Thursday to Sunday.
. . . . "I think the president's party is lowering the gas prices until the people think the economy is settling down, and then they will raise the price again, blaming it on the Arabs for raising the price on barrels of oil," one respondent said. Link Here (10-27-06)
The problem with this type of reasoning is, of course, that it’s hard to explain how “they” (whoever “they” are) in the president’s party would have control over the gasoline prices. So, for now, keep that in the back of your mind and let’s go on to examine other explanations floating around out there.
Ask the Experts
The Seattle Times recently reported on the observations of energy market analysts:
. . . "All the hurricane flags are flying" in oil markets, said Philip Verleger, a noted energy consultant who was a lone voice several years ago in warning that oil prices would soar. Now, he says, they appear to be poised for a dramatic plunge.
. . . For most of the past two years, oil prices have risen because the world's oil producers have struggled to keep pace with growing demand, particularly from China and India. Spare oil-production capacity grew so tight that market players feared that any disruption to oil production could create shortages.
Fear of disruption focused on fighting in Nigeria, escalating tensions over Iran's nuclear program, violence between Israel and Lebanon that might spread to oil-producing neighbors, and the prospect that hurricanes might topple oil facilities in the Gulf of Mexico.
Oil traders bet that such worrisome developments would drive up the future price of oil. Oil is traded in contracts for future delivery, and companies that take physical delivery of oil are just a small part of total trading. Large pension and commodities funds are the big traders and they're seeking profits. They've sunk $105 billion or more into oil futures in recent years. . . according to Verleger. Their bets that oil prices would rise in the future bid up the price of oil.
That, in turn, led users of oil to create stockpiles as cushions against supply disruptions and even higher future prices. . . .
But many of the conditions that drove investors to bid up oil prices are ebbing. Tensions over Israel, Lebanon and Nigeria are easing. The hurricane season has presented no threat so far to the Gulf of Mexico. The U.S. peak summer driving season is over, so gasoline demand is falling.
With fear of supply disruptions ebbing, oil prices began sliding. With oil inventories high, refiners that turn oil into gasoline are expected to cut production. As refiners cut production, oil companies increasingly risk getting stuck with excess oil supplies. There's already anecdotal evidence of oil companies chartering tankers to store excess oil.
All this is turning financial markets increasingly bearish on oil.
"If we continue to build inventories, and if we have a warm winter like we had last winter, you could see a large fall in the price of oil," said Gary Pokoik, who manages Hedge Ventures Energy in Los Angeles, an energy hedge fund. "I think there is still a lot of risk in the market."
Should oil traders fear that this downward price spiral will get worse and run for the exits by selling off their futures contracts, Verleger said, it's not unthinkable that oil prices could return to $15 or less a barrel, at least temporarily. That could mean gasoline prices as low as $1.15 per gallon.http://seattletimes.nwsource.com/html/businesstechnology/ 2003257679_oilconsumers14.html (10-27-06)
Look What We Found!
Thecomment that traders are “bearish” means that they don’t anticipate that buying oil futures will be profitable. In other words, buying oil now with the intent of selling it at higher prices in a few months is not likely to continue, and that is good news for consumers.
We probably should remember that futures traders aren’t the only ones whose expectations can affect a market. Gasoline consumers’ buying decisions today are also affected by their anticipation of tomorrow’s prices. Consider the reaction of consumers – not just drivers like you and me, but also big industrial users and gasoline retailers – to Chevron’s announcement earlier this month that it had “. . . successfully extracted oil from a test well in the deep waters of the Gulf of Mexico, an achievement that could be the biggest breakthrough in domestic oil supplies since the opening of the Alaskan pipeline.” [emphasis added]
Here’s the story:
Major U.S. Oil Source Is Tapped
. . . The announcement helped dampen fears that oil supplies would be swamped by growing global demand, a concern that helped lift oil to record highs this summer, unadjusted for inflation.
. . . Chevron would not estimate how much its reserves would be increased as a result of the test . . . [but did say] that it now believes the lower tertiary region of the Gulf could hold reserves of 3 billion to 15 billion barrels of oil. Total established U.S. reserves are estimated at less than 30 billion barrels.
"Until now no one was sure if the oil in this play would flow," said Zoe Sutherland, North American oil exploration analyst for Wood Mackenzie, a global oil research and consulting firm. "It doesn't matter how many large discoveries you have if you can't produce it. This is very exciting news."
Sutherland said it is fair to compare the breakthrough with the opening up of the North Slope of Alaska in terms of U.S. supply.
Ohio Northern University Professor A. F. Alhajji said the implications of this successful test could also help to open greater offshore supplies at other fields around the globe. He said that could mean even greater addition to worldwide reserves than those that now seem to be within reach in the Gulf.
. . . Gheit said that it is only with oil at its current historically high prices that exploration at these depths really became economically practical.
"This is the silver lining of higher oil prices," he said. "If we didn't have higher oil prices, they wouldn't have dared to risk this much capital here." http://money.cnn.com/2006/09/05/news/companies/chevron_gulf/index.htm (10-27-06)
What About OPEC?
Futures traders, new discoveries, technology advances . . . What else could affect expectations about the supply of oil? Cartels, like OPEC – the Organization of Petroleum Exporting Countries. As sellers, OPEC members naturally prefer to see the retail price of gas rising, not falling – and remember from your economics lessons that restricting the supply of oil is how a cartel keeps market prices higher. To make that happen requires member countries have to all agree to keep oil production low. The International Herald Tribune reports that lately, that’s easier said than done.
After a week of informal talks, the president of OPEC, Edmund Daukoru, said Wednesday that the cartel had agreed to trim oil production by one million barrels a day, although its members were still negotiating over how the cut would be allocated among them.
The confusion surrounding the position of the Organization of Petroleum Exporting Countries, and the group's inability to reach a formal agreement quickly, sent oil prices falling to their lowest level of this year. Some OPEC members want an emergency meeting next week to complete the accord.
OPEC is not a homogenous group, but a collection of countries with divergent political and economic interests. As oil prices more than doubled over the past three years, OPEC members found it easy to agree on a common policy that brought them windfall revenue.
But with prices now falling, that consensus is fraying. Iran and Venezuela have called for a special meeting in Vienna next week to endorse production cuts. Others, like Kuwait and Algeria, have backed the proposal but disagree on how to apportion the cuts. . . .
This is the time OPEC should have been bracing itself for the first quota cut in two years. Instead, as an analyst from Société Générale noted, "OPEC failed its return to discipline."
The group's most influential member, Saudi Arabia, has remained conspicuously silent. The Saudis are understood to support a production cut, but OPEC watchers reason that the country, which accounts for one-third of OPEC's output, wants to be discreet, with midterm U.S. elections just weeks away. http://www.iht.com/articles/2006/10/11/business/opec.php (10-27-06)
Expectations Matter
Market prices emerge from the decisions made by buyers and sellers, and expectations about the future affect those decisions. Recently, a coincidence of events – a calming of war and weather, new discoveries, and evidence of weakness in the oil cartel – has reduced worries about the future availability of oil and gasoline. Seems we’re on a down slope of the gas price roller coaster. Things can change quickly on roller coasters, but for now, we might as well enjoy the downward ride.
Discussion Questions
- Check out the trend in gas prices nationally and compare trends in your local area to those in other regions of the country. The websites below provide data on national trends and regional price history.
- Describe the trend in gas prices at the national level. How have prices changed over the past week? Year? Two years?
- How does this (national) trend compare to that in your local area?
- What evidence is offered in the reading that a conspiracy is responsible for the changing gas prices?
- There are many factors that can cause changes, or shifts, in demand and supply, thereby affecting the market (equilibrium) price and quantity of gas sold at any given time.
- List the factors that can cause changes (shifts) in demand. In supply.
- Which of these factors do you think has contributed to the recent change in the price we pay at the pump?
- List the reasons offered in the reading to explain the recent drop in gas prices. Which of the factors discussed by the author are demand side effects? Supply side effects?
- Demonstrate each of the effects touted by analysts (listed in question #4) on the (blank) supply and demand graph below.
- The articles focus on how the expectations of futures traders and big industrial and commercial buyers of oil impact the oil market. How do you think news of the Gulf find will influence the behavior of everyday consumers like you and me in the (retail) gas market?
- Why is the Chevron discovery referred to as “the silver lining of higher oil prices”?
- What role does technology and innovation play in this story? What incentives are present for crude suppliers concerning technology?
- Why does the current situation make it difficult for OPEC to reach an agreement? What are the implications for the gasoline market if OPEC does agree to cut production? If the members cannot reach agreement?
- What would you like to know to successfully predict gasoline price changes in the next year?
Teacher Guide to Discussion Questions
- Check out the trend in gas prices nationally and compare trends in your local area to those in other regions of the country. The websites below provide data on national trends and regional price history.
- Describe the trend in gas prices at the national level. How have prices changed over the past week? Year? Two years?
- How does this (national) trend compare to that in your local area?
Answers will vary over time. (As of the end of October, on a national level, prices are down $0.035 since last week, and down $0.499 for the year.)
- What evidence is offered in the reading that a conspiracy is responsible for the changing gas prices? There is little, if any, direct evidence to validate this claim. However, the opinion in the last excerpt – that the Saudis are reluctant to agree to production cut-backs does suggest the possibility that the Saudi Arabian government may wish to keep supply high and prices low.
- There are many factors that can cause changes, or shifts, in demand and supply, thereby affecting the market (equilibrium) price and quantity of gas sold at any given time.
- List the factors that can cause changes (shifts) in demand. In supply.
- Which of these factors do you think has contributed to the recent change in the price we pay at the pump?
Specific terminology used varies across textbooks. A common listing of the factors that can cause a change in demand might include: consumer tastes and preferences, consumer income, the prices of related goods (substitutes and complements), consumer expectations, and the number of buyers. A common listing of the factors which could cause a change in supply might include the price of inputs, technology/productivity, producer expectations, and number of producers.
Students can make cases for a variety of answers. For example, tastes & preferences might be cited, as people tend to drive less once the summer vacation season is over. Changes on the supply side may also be cited, such as a change in the price of inputs- crude oil in this case. The article below mentions producer expectations, as (non-retail) oil users had been stockpiling supplies to guard against future price increases.
- List the reasons offered by the article to explain the recent falling gas prices. Which of the factors discussed by the author are demand side effects? Supply side effects? The reduction of stockpiling by big users worried about Mideast violence and/or fear of natural disasters (demand and supply); declining activity in oil futures markets (demand), the end of peak summer driving season (demand); the announcement of the Chevron discovery(demand); and the inability of OPEC to reach an agreement to cut production (supply).
- Demonstrate each of the effects touted by analysts (listed in question #4) on the (blank) supply and demand graph below.
- The articles focus on how the expectations of futures traders and big industrial and commercial buyers of oil impact the oil market. How do you think news of the Gulf find will influence the behavior of everyday consumers like you and me in the (retail) gas market? Consumers may experience a sense of relief; the general public may become less concerned that “running out” of oil is imminent. Because demand for gas is relatively inelastic, expectations for the future are very important to the market. It’s often difficult for people to change their behavior and cut back on gas usage in the short run. For example, many people would find it difficult to buy a new, more fuel-efficient car in the short term, given the relative size of this expense. However, if people are no longer concerned about the future of gas prices, they are less likely to modify their behavior in either the short or the long run.
- Why is the Chevron discovery referred to as “the silver lining of higher oil prices”? Because gas prices have been at all-time highs, oil companies have had an extremely strong incentive to find and supply more oil. When prices are relatively low, there is less incentive for producers to supply more. Because higher prices encourage and provide the money for exploration, consumers stand to benefit tomorrow from paying higher prices today. If the oil discovery is as large as is believed, it significantly increases U.S. oil reserves.
- What role does technology and innovation play in this story? What incentives are present for crude suppliers concerning technology? The incentives created by higher gas prices spurred improvements in the technology of recovering oil from very deep deposits. Necessity may be the mother of invention, but higher prices are certainly the mother of this oil discovery. Not only has technology lowered production costs, it’s also increased the real quantity of the resource needed for production.
- Why does the current situation make it difficult for OPEC to reach an agreement? What are the implications for the gasoline market if OPEC does agree to cut production? If the members cannot reach agreement? Given that OPEC members are suddenly receiving lower prices for their oil than they have been, the temptation to produce more to generate more revenue is likely to be very strong, particularly if they can do it without detection when other members have cut production. It is generally easier to convince fellow members to scale back production when crude prices are high rather than low. If they are able to reach agreement, and they do scale back production, this may cause the price if crude oil to increase, or at least stem the decrease in prices.
- What would you like to know to successfully predict gasoline price changes in the next year? A crystal ball would come in handy! But since they’re very scarce, let’s return to what the reading suggests. If we could predict the supply and demand shifts over the next year, we’d have a good shot at predicting price changes.
On the demand side, we’d need to know things like; changes in consumer’s expectations of future prices; whether technology will emerge during the year that will increase fuel mileage or reduce the price of cars or transportation alternatives; changes in the expectations of oil futures traders and big industrial users of oil; and even the growth rate of auto use in China.
On the supply side it would help to know: how much oil OPEC will offer for sale during the year; whether hurricanes or other natural disasters will reduce supply; whether new discoveries of oil will come online; and whether there will be significant discoveries of new technology in oil exploration, extraction, and refining.