Oil and Gas Prices in the United States
Crude oil is a commodity that is traded in global markets. The prices are determined by supply and demand in the global economy. The United States produces and supplies 8.91% of the world's oil supply [Wikipedia, "List of countries by oil production"] and consumes 22.6% of the global demand [NationMaster.com]. Recent large increases in demand have come from emerging economies such as China and India, but the United States still consumes more than the next three largest oil consumers combined (China, Japan, and India).
Oil prices are very much demand-driven. A recent study by economists at the St Louis Federal Reserve Bank looked at four components of oil prices: global supply, global demand, inventory demand, and speculation. The study concluded that changes in demand accounted for about 40% of the price changes over the past decade. The second largest contributing factor was speculation at 15%, with changes in inventories the third largest factor, and changes in supply the smallest factor.
The changes in demand largely stem from growth in the emerging economies of China and India. The global economic downturn in 2008 accounted for a large decrease in demand.
What are the actual price changes for gasoline in the United States in recent years? Consider the following three charts, which track monthly price changes since the year 2000:
The first chart shows changes in an index of gasoline prices since the year 2000. The second chart shows the core inflation numbers (which is "all items less food and energy"), as measured by the CPI, for the same time period. The third chart shows the combined CPI, which includes all items.
The most obvious conclusion to be drawn from these charts is that gasoline prices are extremely volatile compared to the CPI. Normal inflation (CPI) has been particularly stable during this time period. Prices tend to go up, slowly but in a stable manner. Gasoline prices, on the other hand, have had many wild swings, both up and down. These wild swings have a direct impact on the overall economy.
Another conclusion that can be drawn from these charts is the overall, long term trend. Putting the wild swings aside for a moment, look at the long term trend in gas prices, as indicated by the white line on the first chart above. The long term trend is upward. Long term, gasoline prices do continue to increase. The rate of increase, as measured by the slope of the white line, is slightly higher than the rate of increase of prices in general, as measured by the slopes of the lines in the second and third charts.
Actually, the second chart, which shows changes in the CPI, includes an upward bias that is not present in the first chart of gasoline prices. The CPI does not take into consideration product improvements, including technological advances. This upward bias is probably relatively small when looking at month to month changes, but it means that the line on the graph would be flatter without it. No such upward bias exists in gasoline prices, since gasoline doesn't tend to come in new models every year.
Back to the issue of the price volatility of gasoline, the wild up and down swings. If you look at the price changes in percentage terms, you will see that a somewhat regular pattern exists. Here is a chart showing the percentage change in gasoline prices for the same time frame as the first three charts:
Notice here that an apparently normal business cycle emerges, with peaks and troughs in gas prices occurring roughly once every quarter. Notice also that the degree of volatility, as measured by the length of the up and down movements, has apparently diminished somewhat since the beginning of the economic recovery in 2009. The obvious abnormality is the large drop in 2008. That corresponds to the global financial crisis and Great Recession.
While doing the research needed to create these graphs, it was discovered that the degree of volatility in gasoline prices increased tremendously with a spike in 1999, and continued through 2008. What is the cause of this? I don't know, but I believe it is something that needs to be looked into. Here is the entire trend, starting in 1978 with the earliest data available from this data source. Notice the difference between the degree of up and down movement prior to 1999, compared with after 1999:
What impact does all of this have on the overall economy?
Gasoline prices, and prices of other oil derivatives used for fuel, affect the cost of almost everything. Anything that requires fuel for shipping and / or storage will have cost increases when the price of fuel goes up. On the other hand, they will have cost decreases when the prices go down. The overall, long term trend is that prices for gasoline increase faster than the average of other prices in the economy, but not by much. The long term trend probably is not a large factor. The short term volatility, though, means less business and consumer confidence, less risk taking in investments, and therefore less production is likely to occur.
Different classes of individuals and companies will be affected differently, depending on the degree to which they depend on gasoline for their livelihoods. Gasoline tends to be very inelastic (meaning that people will pay a higher price to purchase roughly the same quantity) compared to most products, but some people have demands that are more inelastic than other people's demands. When costs go up more than incomes, consumption of other goods and services, and savings both decrease.
What are the policy implications of gas prices? What can our politicians do about the problems?
In order to truly deal with the problem, facts must me separated from fiction; reality must be separated from rhetoric. This will not be easy to accomplish, because of the polarized political climate in the United States. Policy positions are being developed on the right and on the left that rely as much on rhetoric as on reality, that appeal to party bases and emotions. What follows here is an attempt to deal with the facts only. It will completely satisfy neither the right nor the left. It will agree with neither party's position on the issue.
What can and should policy makers do about the price of gasoline?
Take a look at the four factors of oil prices listed by the St Louis Fed's economists:
Global supply
Global demand
Oil Inventory demand
Speculation
Global Supply: It has been noted above that the United States produces 8.91% of the world's oil supply, and that prices are determined in a global market. What can policy makers do about this?
Can the United States government increase the global supply of oil, enough to create a significant drop in the global price? To a large extent, oil companies have access to the known oil reserves. They extract what is economically feasible. In order to induce them to drill more, the prices would have to rise, not fall, significantly. A higher price for gasoline would be the cost of a larger supply. This wouldn't solve the price problem, and the higher price necessary would mean a lower standard of living, but it would increase the availability of fossil fuels. The higher price would be an incentive to speed up development of alternative energy sources.
What about concentrating on a large increase in domestic production to decrease domestic prices?
The markets would still be global. Any increase in production would have to be large enough to affect the global price. Can, and should, United States policy be designed to accomplish this? As noted above, the United States produces 8.91% of the world's oil supply. But we only have about 1.6% of the world's known oil reserves. We are already drilling a larger percentage of our reserves than the rest of the world. Much of what we have available is already controlled by oil companies, and will only be extracted if the long term price increases significantly, or if technological advances make drilling more economical. The oil reserves that would require additional government approval make up a small amount of known feasible reserves, and cannot possibly be enough to lower the global price significantly. Tapping into this area would require significant compromises regarding the political hot topic of external (environmental) costs.
Just as importantly, the St Louis Fed study found that changes in supply account for a very small portion of changes in price. The industry is demand driven. The political slogan "drill, baby, drill" is not a reality based solution. It is pure rhetoric that cannot solve our current problems.
What about supply from sources outside the United States? Can the U.S. government influence that? It is worth making every diplomatic attempt to make sure that the fair trade practices are observed, including the prices of exports to the United States. The question then would become, can we do more in this regard than we are already doing? I'm not in a position to give a valid answer to that question. I am not convinced that free trade today is all that free. This is definitely something to look into.
Global Demand: It has been noted above that the United States consumes by far the largest share of oil, but that increases in demand have come from China and India. However, demand is by far the most significant factor in oil prices, so a change in global demand would be a logical place to look for ways to cut prices.
What could policy makers do in this regard? Convince people to cut back on energy use, and at the same time encourage the production of alternative energy sources. Both of these ideas have political drawbacks. Laws have been passed requiring higher fuel standards; people have been encouraged to demand vehicles with higher fuel mileage - these ideas have been scoffed at for being too "liberal". But it cannot be denied that anything that increases demand also increases price. If you choose to consume more energy, you are contributing to increases in energy prices.
Oil Inventory Demand: I mention this because it is one of the factors in the pricing of oil. But I have seen no stories, no studies, to indicate that this is an area that needs "corrected". So I will pass on making any suggestions.
Speculation: It has been noted that speculation accounts for about 15% of the price changes in oil. The way that speculation works: investors buy futures contracts in the anticipation of prices increasing in the future. They can turn around and sell these contracts in order to trade them for contracts that go further into the future. This puts upward pressure on current prices as well. When more speculators sell than buy, the prices go back down. It appears that this speculation not only increases prices, but also increases the volatility of prices. The argument for legal speculation usually includes the idea that speculators provide the service of decreasing volatility; it appears that this argument is not valid when it comes to speculating on commodities such as crude oil.
Policy makers can put restrictions on speculation, or pass laws to discourage the activity. But keep in mind, speculation is a relatively small (15%) part of the price equation. Such policy changes may help, but probably not as much as some people (largely left of center politically) would expect.
The bottom line: policies that are designed to increase domestic production will fail to achieve a goal of decreasing gasoline prices.
In order to significantly increase supplies, either prices will have to be increased significantly or trade needs to be made less "free" and more "fair".
Prices can be decreased with a decrease in demand. There is plenty of leeway in demand to accomplish this economically. But perhaps not politically. It seems that politics is the stumbling block here.
What about a completely different approach? What about the idea of "following the money"? A lot has been made, especially from those on the left end of the political spectrum, that large profits for oil companies are "obscene" when prices are high and people are suffering as a result. What about taxing these profits?
Taxing oil company profits will not decrease prices. It may or may not increase prices, depending on many factors that I don't want to take the time to go into here, but there definitely will be no forces for lower prices unleashed by higher taxes. It is true, however, that oil company profits increase when prices increase. Does that mean that oil companies are responsible for the higher prices? Let's see the proof of that before blaming them. But in the meantime, here is an idea that might help: Since oil company executives have gone before Congress and publicly stated that they are not responsible for higher prices, and since they do indeed receive windfall profits from higher prices, why can't those Congressional hearings be designed to convince the oil company executives to give back their windfall profits, or at least to turn down the subsidies (negative taxes) voluntarily? They just might do that as a result of such a public hearing. They wouldn't just go out and do such a thing on their own, but if they publicly state that they get these profits but don't earn them, perhaps Congress can convince them to give them back. This will not lower gasoline prices, but it could take away unearned profits and give the money back to the American people.
[A note on the difference between oil prices and gasoline prices:
Oil, in the context of gasoline, refers to crude oil. Crude oil, or unrefined oil, is also known as petroleum. When petroleum is refined, it is converted into a number of petroleum-based products. Each product is sold in a separate set of markets. Some of these products are used as fuel, some are not. The largest share is used for fuel products, and gasoline comprises a large share of the fuel products.
Crude oil and gasoline, therefore, have different markets, and therefore different pricing trends. The prices should be closely related, since crude oil is the major resource used in the production of gasoline, and since gasoline comprises such a large percentage of the uses of crude oil. Still, there will be differences due to changes in demand for each market, changes in inventories, and speculation in the commodities markets.
The analysis in this blog largely applies to both crude oil and gasoline. Some of the statistics presented are based on oil, some on gasoline. But the difference should not factor into the conclusions.]
Oil prices are very much demand-driven. A recent study by economists at the St Louis Federal Reserve Bank looked at four components of oil prices: global supply, global demand, inventory demand, and speculation. The study concluded that changes in demand accounted for about 40% of the price changes over the past decade. The second largest contributing factor was speculation at 15%, with changes in inventories the third largest factor, and changes in supply the smallest factor.
The changes in demand largely stem from growth in the emerging economies of China and India. The global economic downturn in 2008 accounted for a large decrease in demand.
What are the actual price changes for gasoline in the United States in recent years? Consider the following three charts, which track monthly price changes since the year 2000:
The first chart shows changes in an index of gasoline prices since the year 2000. The second chart shows the core inflation numbers (which is "all items less food and energy"), as measured by the CPI, for the same time period. The third chart shows the combined CPI, which includes all items.
The most obvious conclusion to be drawn from these charts is that gasoline prices are extremely volatile compared to the CPI. Normal inflation (CPI) has been particularly stable during this time period. Prices tend to go up, slowly but in a stable manner. Gasoline prices, on the other hand, have had many wild swings, both up and down. These wild swings have a direct impact on the overall economy.
Another conclusion that can be drawn from these charts is the overall, long term trend. Putting the wild swings aside for a moment, look at the long term trend in gas prices, as indicated by the white line on the first chart above. The long term trend is upward. Long term, gasoline prices do continue to increase. The rate of increase, as measured by the slope of the white line, is slightly higher than the rate of increase of prices in general, as measured by the slopes of the lines in the second and third charts.
Actually, the second chart, which shows changes in the CPI, includes an upward bias that is not present in the first chart of gasoline prices. The CPI does not take into consideration product improvements, including technological advances. This upward bias is probably relatively small when looking at month to month changes, but it means that the line on the graph would be flatter without it. No such upward bias exists in gasoline prices, since gasoline doesn't tend to come in new models every year.
Back to the issue of the price volatility of gasoline, the wild up and down swings. If you look at the price changes in percentage terms, you will see that a somewhat regular pattern exists. Here is a chart showing the percentage change in gasoline prices for the same time frame as the first three charts:
Notice here that an apparently normal business cycle emerges, with peaks and troughs in gas prices occurring roughly once every quarter. Notice also that the degree of volatility, as measured by the length of the up and down movements, has apparently diminished somewhat since the beginning of the economic recovery in 2009. The obvious abnormality is the large drop in 2008. That corresponds to the global financial crisis and Great Recession.
While doing the research needed to create these graphs, it was discovered that the degree of volatility in gasoline prices increased tremendously with a spike in 1999, and continued through 2008. What is the cause of this? I don't know, but I believe it is something that needs to be looked into. Here is the entire trend, starting in 1978 with the earliest data available from this data source. Notice the difference between the degree of up and down movement prior to 1999, compared with after 1999:
What impact does all of this have on the overall economy?
Gasoline prices, and prices of other oil derivatives used for fuel, affect the cost of almost everything. Anything that requires fuel for shipping and / or storage will have cost increases when the price of fuel goes up. On the other hand, they will have cost decreases when the prices go down. The overall, long term trend is that prices for gasoline increase faster than the average of other prices in the economy, but not by much. The long term trend probably is not a large factor. The short term volatility, though, means less business and consumer confidence, less risk taking in investments, and therefore less production is likely to occur.
Different classes of individuals and companies will be affected differently, depending on the degree to which they depend on gasoline for their livelihoods. Gasoline tends to be very inelastic (meaning that people will pay a higher price to purchase roughly the same quantity) compared to most products, but some people have demands that are more inelastic than other people's demands. When costs go up more than incomes, consumption of other goods and services, and savings both decrease.
What are the policy implications of gas prices? What can our politicians do about the problems?
In order to truly deal with the problem, facts must me separated from fiction; reality must be separated from rhetoric. This will not be easy to accomplish, because of the polarized political climate in the United States. Policy positions are being developed on the right and on the left that rely as much on rhetoric as on reality, that appeal to party bases and emotions. What follows here is an attempt to deal with the facts only. It will completely satisfy neither the right nor the left. It will agree with neither party's position on the issue.
What can and should policy makers do about the price of gasoline?
Take a look at the four factors of oil prices listed by the St Louis Fed's economists:
Global supply
Global demand
Oil Inventory demand
Speculation
Global Supply: It has been noted above that the United States produces 8.91% of the world's oil supply, and that prices are determined in a global market. What can policy makers do about this?
Can the United States government increase the global supply of oil, enough to create a significant drop in the global price? To a large extent, oil companies have access to the known oil reserves. They extract what is economically feasible. In order to induce them to drill more, the prices would have to rise, not fall, significantly. A higher price for gasoline would be the cost of a larger supply. This wouldn't solve the price problem, and the higher price necessary would mean a lower standard of living, but it would increase the availability of fossil fuels. The higher price would be an incentive to speed up development of alternative energy sources.
What about concentrating on a large increase in domestic production to decrease domestic prices?
The markets would still be global. Any increase in production would have to be large enough to affect the global price. Can, and should, United States policy be designed to accomplish this? As noted above, the United States produces 8.91% of the world's oil supply. But we only have about 1.6% of the world's known oil reserves. We are already drilling a larger percentage of our reserves than the rest of the world. Much of what we have available is already controlled by oil companies, and will only be extracted if the long term price increases significantly, or if technological advances make drilling more economical. The oil reserves that would require additional government approval make up a small amount of known feasible reserves, and cannot possibly be enough to lower the global price significantly. Tapping into this area would require significant compromises regarding the political hot topic of external (environmental) costs.
Just as importantly, the St Louis Fed study found that changes in supply account for a very small portion of changes in price. The industry is demand driven. The political slogan "drill, baby, drill" is not a reality based solution. It is pure rhetoric that cannot solve our current problems.
What about supply from sources outside the United States? Can the U.S. government influence that? It is worth making every diplomatic attempt to make sure that the fair trade practices are observed, including the prices of exports to the United States. The question then would become, can we do more in this regard than we are already doing? I'm not in a position to give a valid answer to that question. I am not convinced that free trade today is all that free. This is definitely something to look into.
Global Demand: It has been noted above that the United States consumes by far the largest share of oil, but that increases in demand have come from China and India. However, demand is by far the most significant factor in oil prices, so a change in global demand would be a logical place to look for ways to cut prices.
What could policy makers do in this regard? Convince people to cut back on energy use, and at the same time encourage the production of alternative energy sources. Both of these ideas have political drawbacks. Laws have been passed requiring higher fuel standards; people have been encouraged to demand vehicles with higher fuel mileage - these ideas have been scoffed at for being too "liberal". But it cannot be denied that anything that increases demand also increases price. If you choose to consume more energy, you are contributing to increases in energy prices.
Oil Inventory Demand: I mention this because it is one of the factors in the pricing of oil. But I have seen no stories, no studies, to indicate that this is an area that needs "corrected". So I will pass on making any suggestions.
Speculation: It has been noted that speculation accounts for about 15% of the price changes in oil. The way that speculation works: investors buy futures contracts in the anticipation of prices increasing in the future. They can turn around and sell these contracts in order to trade them for contracts that go further into the future. This puts upward pressure on current prices as well. When more speculators sell than buy, the prices go back down. It appears that this speculation not only increases prices, but also increases the volatility of prices. The argument for legal speculation usually includes the idea that speculators provide the service of decreasing volatility; it appears that this argument is not valid when it comes to speculating on commodities such as crude oil.
Policy makers can put restrictions on speculation, or pass laws to discourage the activity. But keep in mind, speculation is a relatively small (15%) part of the price equation. Such policy changes may help, but probably not as much as some people (largely left of center politically) would expect.
The bottom line: policies that are designed to increase domestic production will fail to achieve a goal of decreasing gasoline prices.
In order to significantly increase supplies, either prices will have to be increased significantly or trade needs to be made less "free" and more "fair".
Prices can be decreased with a decrease in demand. There is plenty of leeway in demand to accomplish this economically. But perhaps not politically. It seems that politics is the stumbling block here.
What about a completely different approach? What about the idea of "following the money"? A lot has been made, especially from those on the left end of the political spectrum, that large profits for oil companies are "obscene" when prices are high and people are suffering as a result. What about taxing these profits?
Taxing oil company profits will not decrease prices. It may or may not increase prices, depending on many factors that I don't want to take the time to go into here, but there definitely will be no forces for lower prices unleashed by higher taxes. It is true, however, that oil company profits increase when prices increase. Does that mean that oil companies are responsible for the higher prices? Let's see the proof of that before blaming them. But in the meantime, here is an idea that might help: Since oil company executives have gone before Congress and publicly stated that they are not responsible for higher prices, and since they do indeed receive windfall profits from higher prices, why can't those Congressional hearings be designed to convince the oil company executives to give back their windfall profits, or at least to turn down the subsidies (negative taxes) voluntarily? They just might do that as a result of such a public hearing. They wouldn't just go out and do such a thing on their own, but if they publicly state that they get these profits but don't earn them, perhaps Congress can convince them to give them back. This will not lower gasoline prices, but it could take away unearned profits and give the money back to the American people.
[A note on the difference between oil prices and gasoline prices:
Oil, in the context of gasoline, refers to crude oil. Crude oil, or unrefined oil, is also known as petroleum. When petroleum is refined, it is converted into a number of petroleum-based products. Each product is sold in a separate set of markets. Some of these products are used as fuel, some are not. The largest share is used for fuel products, and gasoline comprises a large share of the fuel products.
Crude oil and gasoline, therefore, have different markets, and therefore different pricing trends. The prices should be closely related, since crude oil is the major resource used in the production of gasoline, and since gasoline comprises such a large percentage of the uses of crude oil. Still, there will be differences due to changes in demand for each market, changes in inventories, and speculation in the commodities markets.
The analysis in this blog largely applies to both crude oil and gasoline. Some of the statistics presented are based on oil, some on gasoline. But the difference should not factor into the conclusions.]
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