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Why Do Gasoline Prices React to Things That Have Not Happened?

Monday, October 1, 2007
oil and gasoline prices move together | chart | St. Louis Fed


Have you ever wondered why gasoline stations raise their prices in response to fears about future supplies of oil? You may have thought to yourself, "I know the gasoline in the station's underground storage tank was purchased before the world price increased. How can they raise the gas price now? The gasoline market must be rigged."

In fact, gasoline stations should raise their prices to reflect increased future costs of replacing their inventories. Prices act like engine or voltage regulators - they automatically speed up or slow down the flow of the commodity in order to maximize performance, or what economists call allocative efficiency. (Consumers get the goods for which they are willing and able to pay.)


Oil and Gas, Here and There, Then and Now

To understand why U.S. gas prices respond now to things that might happen in the future, halfway around the world, one must understand how spot and futures prices for storable commodities, such as oil or gasoline, are related to each other.

The cost of oil comprises about half the cost of gasoline, but oil is the most volatile component; other factors, such as taxes and profit margins, do not change often.

The figure above shows that while gasoline prices can diverge from oil prices for short periods because of seasonal demand, tax changes or other reasons, the two prices are closely linked over longer periods.

Because oil can be transported anywhere, trading on global spot and futures markets determines the global price of a given grade of oil, aside from local taxes and transportation costs. Oil can either be sold for immediate delivery or stored for sale in the future; so, firms adjust their inventories in response to news about the future supply and/or demand for oil.

Because oil is such an important component of gasoline, wholesale gasoline prices react instantly to changes in oil prices, including those caused by expectations of future events. The price at your local gas station will change nearly as quickly as the wholesale price.

Let's see how two hypothetical competing gasoline stations in a small town might react to a sudden increase in the price of oil. On one quiet morning, both the Conch Gas station and the Pegasus Gas station were charging $1.999 per gallon of regular gasoline. They each had bought their inventories a few days before at a cost of $1.48 per gallon. With federal, state and local taxes combining for 50 cents per gallon, each station calculated that it would make about 2 cents per gallon at a retail price of $1.999.

During the late morning, news of an unsuccessful terrorist attack on Saudi Arabian oil fields spurred widespread fears of cuts in future oil supplies. As frenzied trading on exchanges in New York, London and elsewhere bid up the world price of oil, the station owners learned that wholesale gasoline prices for delivery next week had increased by $1 per gallon. Both owners raised their prices to $2.99 per gallon.

Despite much grumbling at the price increases, sales at the Conch Gas and the Pegasus Gas stations proceeded much as before - both stations sold out their existing inventories right on schedule and then took delivery on a new load of gasoline at the new, higher wholesale prices. The station owners made a tidy, unexpected profit that week - $1.02 per gallon.


Are the Gas Stations Gouging Us?

Did the stations' simultaneous price changes the week before wholesale prices actually went up prove that Conch Gas and Pegasus Gas were colluding to gouge consumers? No. These competing station owners did not have much choice if they wanted to remain as profitable as their competitors and stay in business over the long haul.

Suppose first that only Conch Gas had held its price at $1.999, while Pegasus Gas had raised its price to $2.999. Conch Gas obviously would have captured all of the traffic that day, but its storage tank would have run dry much sooner than expected. By the first or second day after the overseas disruption in the oil market, the owner-manager of Conch Gas might as well have gone on vacation - unpaid, it should be noted. Meanwhile, the manager of Pegasus Gas - who took his vacation in the first two days of the crisis-returned to sell out his remaining inventory at $2.999 per gallon. In the end, the Pegasus Gas station made a much larger profit.

Now suppose that both Conch Gas and Pegasus Gas decided to show home-town solidarity by keeping their prices at $1.999, at least until the new, higher-cost gasoline inventories arrived in a few days. Local residents certainly would have been appreciative, but so would all of the eager drivers from neighboring towns who would have driven in to enjoy "cheap" gas. Both the Conch and Pegasus stations would have run dry before their replacement inventories arrived. Anyone in this town who was unfortunate enough to need gas on the third day of the crisis would have been out of luck.

What if all the gasoline stations in the state had agreed to keep their prices at $1.999 until higher-cost supplies started arriving? Even if the flow of out-of-state bargain hunters might turn out to be small, a state-wide shortage of gasoline would almost certainly result. Recognizing that gas prices were only temporarily low and were bound to rise soon, all rational owners of cars, trucks, tractors, off-road vehicles, lawn mowers or leaf blowers would fill up their tanks as quickly as possible. That is, any attempt to constrain the retail price of gasoline in the face of higher future prices simply induces a scramble among buyers to beat the price increase. Many people would make wasteful extra trips to top off half-full tanks, and others would be genuinely inconvenienced as shortages developed.

Thus, the simultaneous price increases by Conch and Pegasus Gas are not harmful price gouging at all. Although no one likes to pay more for gas, market-determined gasoline prices operate to prevent shortages and maximize economic efficiency.