August 26, 2014

What You Want To Know About Oil And Gasoline, But Probably Don’t

Gas-price

Texas A&M experts answer reader questions about oil and gasoline prices

We asked readers, “What do you want to know about oil and gasoline prices?” For answers, we looked to Texas A&M University Professor Detlef Hallermann, a faculty member in the Department of Finance and a petroleum engineer who specializes in the energy sector, and Professor Sorin Sorescu, a faculty member in the Department of Finance who specializes in market efficiency.

Who decides how much we pay at the pump, and why do gasoline prices rise and fall all the time?
Professor Sorescu:  The financial traders are the ones who decide. Before the late 1970s, the suppliers of crude oil, particularly OPEC, were very influential in setting the price of oil.  With the arrival of the futures market, the responsibility of determining the oil price has slowly moved away from OPEC to the traders in the futures market exchange, particularly in Chicago. Today, crude oil futures are bought and sold continuously, similar to how stocks are traded. Traders set the price of oil futures based on what they think the oil will be worth in the future.  This way, the futures market responds instantaneously to what traders think might happen later; so if there’s a high probability of war or financial crisis, traders can increase the price because they think the world is a more unstable or risky place. If they’re right and there is a war or financial crisis, they’ll be able to sell the oil at that higher price. Alternatively, if the situation resolves itself, oil would be worth less, and traders would lose money.  Therefore, the rising and falling prices we see reflect, on a minute-by-minute basis, the changing expectations of traders based on the geopolitical climate, macroeconomic and monetary aspects, as well as supply-and-demand forces.

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(from left:) Detlef Hallermann and Sorin Sorescu

Professor Hallermann: I would add to that by saying people are always talking about the evils of the oil companies, but that couldn’t be further from the truth. The goal of the financial market is to put buyers and sellers together. The oil companies’ goal is to be good stewards of their shareholders’ money. The EIA and CFTC are government entities that provide oversight to the pump price. Markets are competitive, this is capitalism, so anytime a company can be more efficient, it does what it needs to do to manage costs. It’s all part of the daily activities; the oil companies are not “out to get” consumers.

Some people say that the President is responsible for high gas prices. Is that true? 

Professor Sorescu: I don’t see how the President can have a direct effect on oil prices given the free market system I just described. The President can have an effect, however, indirectly, based on his domestic and foreign policies that might affect the traders’ outlook of that market.

Why is gas more expensive in some parts of the country than others?
Professor Hallermann: Transportation and storage costs drive up the prices in some parts of the country. If the refineries have to pay to transport the product long distances, they need to charge more. And that goes for global prices as well; gasoline is much more in Europe than in the U.S. because it costs so much more to transport the gasoline overseas. Another reason is that different municipalities have different regulations that affect gas production at the refinery. So for example in Texas, gasoline sold in cities near the Houston Ship Channel, like Pasadena, is refined with different environmental regulations than the gasoline sold in downtown Houston. Gasoline sold in California has different requirements than in Texas. The refineries have to formulate the gas based upon the regional regulations; some of the formulations cost the refineries more money, so they’d need to charge more or less depending on each area’s requirements. Time of the year also makes a difference; in the wintertime, gasoline has more ethanol than in the summertime. So producing different batches during different times of year, for various municipalities, contributes to the price differentials you see around the country.

How does strife in the Middle East affect gasoline prices?
Professor Hallermann: It’s not just the Middle East, when there’s political unrest anywhere worldwide, companies, governments and consumers will buy and hold gasoline. It’s a simple supply-and-demand issue; higher demand causes higher prices and less supply causes higher prices.

We’re bombing ISIS in Iraq right now, so the traders for a refinery start thinking about what could happen to future crude deliveries. Could this turn into a major crisis?  If so, let’s buy crude oil and store it, just in case. If the crisis abates, the trader holds the extra inventory and uses it over time. If it does become a major crisis, the refinery is OK.

Do we really go to war for oil?
Professor Hallermann: Many people say we fought the Gulf War over oil and I don’t believe that’s true. Our government and our free market environment want stability. Iraq invaded Kuwait and we used our military to defend Kuwait and to stabilize the market, not to get oil for our own benefit. Otherwise, we would own “x” of the Kuwaiti reserves. As far as I know, we do not.

Professor Sorescu: We use our military for defense, not for conquering; to protect property rights, not to expropriate. We didn’t go into Iraq or Kuwait to take their oil. We went there to promote democracy and free markets. We did not claim any oil revenue from the Kuwaiti or Iraqi government. We did not expropriate any land from these countries. Even when Mexico fought against us in the 1840s and lost part of its territory, the United States protected property rights that had been previously acquired under Mexican and Spanish rule. Honoring property rights in this context is very rare in world history. President Ronald Reagan put it best when he said “We occupy no country. The only land abroad we occupy is beneath the graves where our heroes rest.” No, we did not start the Gulf War for oil.

What will happen once all the oil in the world is gone?
Professor Hallermann: If one looks at how far recovery technology and alternate fuels technology has advanced in just the last 20 years, I believe there’s nothing to worry about. By the time we’ve extracted the fossil fuels out of the Earth that are recoverable today, technology will have advanced so that we will be using alternate energy sources.

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Top Photo: Shutterstock.com

Media contact: Lesley Henton, Division of Marketing & Communications at Texas A&M University; 979-845-5591, lshenton@tamu.edu

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