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Why Is Gas Almost $4.00 a Gallon?

Hint: Supply and demand have nothing to do with it.

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Why Is Gas Almost $4.00 a Gallon?
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I’m going to admit something to you that may affect how you read this article. Call it full disclosure; call it conscience. You need to know this before we jump into this subject.

I dropped out of high school Economics. There, I said it. I dropped that class and took a study hall. And I did it because of a girl. She had study hall first period and I wanted study hall too. Well, that and the fact that my Econ teacher was nearly senile. Most of us had difficulty in that class. She had a knack for skipping around, teaching from the wrong chapter without realizing it. We flipped pages and looked at each other, desperately trying to keep up. But really, that was just my excuse. It was really the girl.

So, with all that I am about to lay on you, I want you to understand that you can find all this information yourself. I want you to look these things up, get them reduced to simple English, and make up your own mind. I want us to step out of the politicization of it all and get to a real answer. Because, friends, we’ve been lied to. We’ve been told something that simply is not true. We’ve been told this lie by both political parties and every candidate for as long as we can remember. And their sneaky little lie is based on a kernel that used to be true (here comes the “he dropped out of economics” part), and sometimes still is.

Supply and demand.

On your first day in any economics or business class, you learn about supply and demand. They are the two great forces in business. They are what keep a capitalist economy going. Shoot, they are what keeps a communist economy going, for that matter. They are as inescapable as laws of nature. The relationship between scarcity and demand is so basic, that we can seldom see past it to other factors.

If the price of orange juice goes up, we presume a supply and demand issue is at work. Was there a late freeze in orange country that reduced the supply of oranges? Was there a natural disaster that took out processing plants, trucking, etc? Was there a sudden revelation about the magical cancer-fighting properties of orange juice? Does it simultaneously raise your IQ and lower your cholesterol?

If I have 4 apples and there are 40 people wanting to buy apples, I am at an advantage. I can almost name my price. If I have 40 apples and only 4 people are buying, the price is going to drop. It’s Economics 101. I was there long enough to get that. It was on page one.

So, when the price of gasoline hits $4.00 per gallon, as it surely will soon, we can safely assume that something is happening in the supply of gas. We know that demand is rising. People on the radio and television tell us all the time that the Chinese are making cars at a breakneck pace. Even as we try to shave our gas demand, they are ramping up their own.

In my lifetime, there have been multiple instances where the price of oil has spiked. In two of those cases, 1973 and 1979, the spike was caused by international issues. The Arab Oil Embargo in 1973 and the Iranian Revolution in 1979. There were domestic government decisions that factored in to both these cases, but the overall economic factors were the same. In both cases, issues of supply and demand were at work. We simply were not getting – or expecting to get – the oil we needed. At-the-pump prices shot through the roof. People lined up at gas stations to get gas, draining the hoses, hopping on their bumpers to get the last little bit in.

The 1980s saw a “glut”. Oil prices fell to almost a third of their crisis heights. This glut was actually an aftershock of the ’79 issues. Reserves had been cranked up. Conservation efforts had been put in place. Again, it was a matter of supply and demand.

But, there is something funny afoot in our latest gas price hikes. Step back with me to 2008, the year of the last presidential election.

Drill, Baby, Drill!

Matt Taibbi recalls the 2008 presidential campaign season this way:

That summer, as the presidential campaign heated up, the accepted explanation for why gasoline had hit $4.11 a gallon was that there was a problem with the world oil supply… John McCain insisted that ending the moratorium on offshore drilling would be “very helpful in the short term,” while Barack Obama… argued that federal investment in hybrid cars was the way out.

It was in this season that cries of “Drill, Baby Drill!” went up. The answer was simple: Drill in the Gulf. Drill in ANWR. Frack in Canada and pipe it down. And the merits of all of these things were discussed. Some wanted to get away from oil altogether, and as fast as possible. They framed it as a matter of national security. Then-candidate Barack Obama offered a novel idea: let’s do all of it. If we increase our domestic production (supply) AND raise efficiency standards and invest in alternative forms of energy (demand), we could crack this gas price nut once and for all. It was all about getting off foreign oil, controlling our own destiny.

However, as Taibbi points out, the candidates were dancing around the real issue:

But it was all a lie. While the global supply of oil will eventually dry up, the short-term flow has actually been increasing. In the six months before prices spiked, according to the U.S. Energy Information Administration, the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million. Not only was the short-term supply of oil rising, the demand for it was falling — which, in classic economic terms, should have brought prices at the pump down.

So, if demand was decreasing, and supply was increasing…? Maybe this was the part where I took a study hall. It was later that I learned that my Economics teacher never would have taught me the real reason gas prices spiked. That’s because there had never been a commodities market in the kind of shape we saw in 2008 before.

Commodities

Commodities markets are a mystery to most people. We kinda understand stocks. We have gotten pretty good at mutual funds, no problem. But phrases like “pork bellies” and topics like “soybean futures” are not where we typically feel comfortable. But commodities in general, and especially the market forces around commodities, are very much a part of our everyday lives. You don’t have to memorize any definitions about this; there won’t be a test. Afterward you can head off to study hall with me. But listen to how this man very simply explains commodities and the speculation on those commodities.

Get all that?

Commodities have fixed amounts. There is little or no question about supply overall because the supply is averaged out over longer periods. That was the original purpose of the commodities market, actually: to help level out from year to year the volatility of agricultural markets that were so weather-sensitive.

But the freedom to invest in commodities markets has become very attractive as the dollar has fallen. Investors want someplace they can put their money that is going to be insulated from falling demand.

Are you ready for the next piece of that puzzle? Though our friend in the video talked mainly about food prices only mentioned it briefly, oil is a commodity. Can you see where this is going already?

In 1936, Congress empowered the Commodity Futures Trading Commission to place limits on speculative trades in commodities. If speculation was allowed to run unchecked in commodities markets, the very things our friend in the video described would happen. Food prices would skyrocket. Gas prices would spike. Stick with me.

Beginning in 1991, certain investment firms began to secure letters of exception from the SFTC to allow them to trade heavily in commodities.

By the summer of 2008, in fact, commodities speculators had bought and stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that speculators owned more future oil on paper than there was real, physical oil stored in all of the country’s commercial storage tanks and the Strategic Petroleum Reserve combined.

Then, in 2008 when the housing bubble burst, tons of money poured into these markets that was never intended to be there. Investment companies moved their customers’ money from housing-related stocks and funds – including mutual funds for 401K plans of large companies – to commodities.

In fact, so many oil futures were bought that there was not enough oil to cover them all. The value of future oil was now bought. That’s demand. But it’s demand on paper, not you and me at the pump. But it drove prices up and we ended up paying at the pump, dearly.

That was in 2008. What has happened since then?

Oil production in the U.S. is now at the highest it has been in 8 years. The political question about who deserves credit for that aside, it remains that we are producing more oil than since before we invaded Iraq.

The effect of uncontrolled futures trading in oil has caused such a volatility in the market that gas prices have gone from $3.22 a gallon just before Christmas to $3.92 a gallon last week. And every penny of price increase gets the oil companies $200 million dollars in profit.

As the Washington Post reported recently:

Earlier this year, the chief executive of ExxonMobil, Rex Tillerson, estimated that speculation was then contributing an extra $30 a barrel to the price of oil.

But wait. Wasn’t all of this illegal? Did the law get changed? No. But there are ways around those laws. For example…

By law, mutual funds are supposed to derive 90 percent of their income from investments in stocks, bonds and other securities, under the regulatory supervision of the Securities and Exchange Commission. So to get around that prohibition and offer commodity funds, some clever securities lawyers in the mutual fund industry came up with the idea of setting up shell companies in the Cayman Islands for the sole purpose of investing in commodity futures and swaps. By selling shares in the offshore subsidiary to their sponsoring funds, the mutual funds are able to meet the requirement that they only invest in securities, and can also pass the subsidiary’s profits on to mutual fund investors without paying a corporate profit tax. And because these are subsidiaries of mutual funds regulated by securities regulators, they escape oversight of the Commodities Futures Trading Commission.

There is no better proof of all this than this chart. Keep in mind, this is not a chart of oil prices. These are at-the-pump prices.

Gas Prices - Six Years

See that huge dip in 2008? That’s the one you’ve been hearing about in the presidential races. People like to imagine that things were just peachy at the pump before Obama and the current administration messed it all up. I’ll withhold comments about the current administration, but the chart shows the truth. Things were messed up at the pump long before. Then, when the bottom fell out of the market, when Lehman lost everything, when investors ran from everything in sight, gas prices fell too.

This is a market-driven price bubble, not a supply/demand driven one.

So, as this presidential race heats up, don’t buy all the hype about hybrid cars or domestic drilling, no matter what your opinion of those things may be. Those are old supply and demand arguments. I only wish they had an effect on what we pay at the pump. The reality is that investment companies have rigged a side game of betting on the gas you and I pump and that is what is driving our prices up.

I’ll let you form your own opinion about what needs to be done to stop people from gambling on your gas.

Why Is Gas Almost $4.00 a Gallon?
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  • http://www.LAokay.com Steve G

    The reason gas prices dropped was because hardly anybody was buying oil futures when the market dropped so there was a lot of supply that was not already purchased by the futures traders. It didn’t mean there was more supply and less demand. It simply meant that less of it was already spoken for as investors had to use money they would have otherwise invested in things like oil futures to cover their losses in other areas of investment. If you bought up all the gold, the price would skyrocket because everybody would want it and then you could charge whatever you wanted for it. That’s kind of what is happening with oil prices. Everybody is buying up as much as they can to insure that people will simply pay more for it.

  • http://steveg.com SteveG

    This is exactly what is driving the price of gold. Being in the jewelry industry at the time we talked about it a lot before gold was moved to the commodities market. We predicted that a handful of people would get staggeringly rich from the move while at the same time driving gold prices through the roof for no real reason. Unfortunately we predicted it would only double, not quadruple.

    Then silver came on a few months later and it did exactly the same thing.

    My only real question is ‘why’ this was done. There really are just two reasons.

    1. Metals were moved to the commodities markets to allow people with less money to be able to buy in through mutual funds. The idea was, like the housing industry, that it isn’t fair that poor people can’t invest in the things that ‘rich’ people can.

    2. Metals were move to the commodities markets to allow rich people to get even richer. Whether that was the reason or not, it worked.

    The commodities markets have gotten totally out of control. In the past playing the commodities market was a very high risk tactic and most people stayed away. They margins were reduced, making it even easier for people that shouldn’t play to play, and they became the quick buck, easy money, investment to make. Look what it did to everyone.

  • Adam Steele

    I’ve been a commodities trader myself. The only reason I was there was to speculate and earn a buck faster than all the hard working schmucks around me. Then came Lehman and the bottom dropped out of the world.
    This schmuck’s a lot less pluck now.

    I agree with Mike, you see I’ve been in the trenches. The markets dont care a hoot how overpriced a trade is as long as there’s momentum behind it. If it’s going up we chase it all the way up and use fancy quant indicators to tell us when the trend breaks. Some of us wait and pray and lust for the spike, that elusive hard to position trade that snaps your way like a rubber band and carries that trade to dizzying heights of equity.

    Naturally, there’s a price to pay, folly begets greed and fear.
    Some bigger schmuck sitting at a trade far above you begins to notice and all hell breaks loose. Enough said.
    Mike, I get the point.
    Thank you.