Oil Prices: Supply and Demand or Something More Sinister?

There has been a lot of discussion lately about the rising prices of oil and oil-based products (gasoline).  WBZ Boston had a conversation about it (you can find the link and read some of my comments here: http://boston.cbslocal.com/2011/04/11/curious-why-oil-gas-prices-are-rising-so-quickly/ ) and so have many other pundits.  The main question here is this: Why is the price of gasoline rising so quickly?

The answer to this question is very complex.  I will do my best to explain it as best as possible.

Let’s start at the macro-level.  As we all know, there has been lots of unrest recently in the Middle East.  Many of these countries, including Libya, Egypt, and Iran, are suppliers of oil.  While this unrest has not directly affected the supply of oil (when there has been disruptions, other suppliers such as Russia or Saudi Arabia have picked up the slack), it does still affect the price of oil.  There is an expectation that these revolts could disrupt the oil supply and cause higher prices.  In response to this, fuel-dependent industries (such as trucking, shipping, the military, etc.) have been purchasing fuel now while it is still cheap and readily available.  Fuel is a durable good and has a good shelf life.  This is causing upward pressure on the price of oil.

Also, while American demand for fuel is lower than it has been, we do have the rising BRIC countries (Brazil, Russia, India, and China).  These countries are quickly developing into 1st world nations and oil fuels this growth.  Oil is a very cheap fuel, both to refine and in terms of it’s productivity (oil gets you a 600% energy return on your energy used to refine and drill. Source: The Rational Optimist by Matt Ridley, Kindle Edition Location 3,385), so it’s attractiveness to the developing world (and our own uses) is very high.  These countries’ demand for oil is also causing the price to increase.

Finally, do not forget that the US is fighting two wars (Libya and Afghanistan) and we do need oil for our war machine.

How, then, does this answer the question of why gasoline prices rise so quickly?  Simple.  When a station owner makes the decision of what price to charge, he has to take into account his next purchase of fuel.  If he thinks the price will rise for his next shipment, he will charge more now.  Otherwise, he would be unable to afford it.

Let me give you an example.  Let’s assume that your local gas station bought his current supply of gasoline at $2/gal.  Doing some calculations, he reckons that his next  purchase will be $3/gal.  In order for him to afford this, he will charge the price of $3/gal currently.  If he were to charge the price he paid ($2/gal), he would be unable to afford his next shipment and be forced to shut down.

So no, there is nothing more sinister going on.  There is no global oil conspiracy.  I hope, by reading this, the next time someone suggests the oil companies are out to get you, you can be smarter than that.

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2 Responses to Oil Prices: Supply and Demand or Something More Sinister?

  1. youknowwho says:

    So, what happens in your example when the station owner anticipates paying less for his next shipment? Oil has fallen from around 113 to around 107 in the past couple of days, will we start to see prices fall?

    • cityslicker4 says:

      You usually see prices start to drop soon after. Although not quite at the same speed as rising. There is less of an urgency for the owner. Also, if he wants to get a jump on the competition, it’ll be sooner rather than later.

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