Rising Gas Prices Anyone Who

¶ … Rising Gas Prices

Anyone who has filled up their gas tank lately knows that prices have been on the rise for some time. Fluctuations in gasoline at the pump are a reflection of fluctuations in the price of the raw material from which it is made, crude oil (Federal Reserve, 2004). When oil prices peak the public, sparked by the nightly news, tend to overreact. They fantasize about what the world will be like when everyone stays home because they cannot afford gasoline to go places. The picture that some paint is that of economic ruin and despair. However, in reality, the effect of gasoline is not as dramatic as many would believe. The following will examine the real effects of gasoline price fluctuations on the economy.

The first concept that one needs to understand when it comes to gasoline prices is that the nominal price might go up dramatically, but when one adjusts the price for inflation, the price increase appears to be much smaller (Federal Reserve, 2004). There is historic precedence for panic when oil prices soar. In the 1970s and 1980s oil prices did have a dramatic impact on the country. However, there were many factors that were different then, and it is not as likely that the recent price rise will have the dramatic effect that it did back then (Federal Reserve, 2004).

Oil prices are like any other commodity market. They go up and they go down. The real question that one must ask about the most recent oil price rise is whether this is just a temporary spike that will eventually correct itself, or whether it indicates a long-term trend (Federal Reserve, 2004). Ther4e are several indicators that can be useful in making this determination. One of these instruments is to watch options and futures trading.

The Financial Markets and Oil

Predicting the financial markets is not an exact science and no one knows for certain what the future will hold. However, for many, the markets are a high stakes game and there are many skilled players. Contracts for oil futures are traded continuously on an active market. Traders of these commodities know their product inside and out. They are an excellent source for an experienced opinion as to where prices are likely to go in the future (Federal Reserve, 2004). Options markets are also a good source of information as well. These instruments can be a good indicator of the degree of uncertainty that traders feel regarding a certain commodity.

Generally speaking, certainty and stability is good for the economy. Uncertainty and volatility is bad for the economy (Federal Reserve, 2004). Uncertainty tends to make companies cautious when making capital investments (Federal Reserve, 2004). Investors are willing to take their chances on a short-term period of uncertainty. The amount of risk that they are willing to endure depends on the length of time that they expect the uncertainty to last.

Oil futures are especially important for the economy. Oil is a basic need and can be a driving factor in other commodities (Kilian, 2007). Oil effects heating, energy and transportation costs. When oil prices rise, it has a trickle down effect on other commodities. Oil prices affect other products in two primary ways. Oil is a necessary resource for many other products. For products, such as cosmetics that use petroleum products as raw materials the effect of rising oil prices is direct. There is only so much expenditure that can be absorbed before prices must be raised to maintain profit.

For other products oil has a secondary effect. Almost every commodity that is produced must be transported. Transportation requires oil products, such as gasoline and motor oil. Oil is a direct cost for the transportation industry. However, as the price for oil rises and begins to affect the cost of transportation, these costs must be passed on to the end consumer. Therefore, oil also has an indirect effect on other products. For some products, oil has both a direct and an indirect effect. If the product uses oil its manufacture and then the final product must be transported, the effects of oil prices has a double affect.

It is easy to see how rising oil prices could have the potential to wreak havoc on other sectors of the economy from small electronics to the price of agricultural products. The amount of direct effect and indirect effect differs from segment to segment and from product to product. The effect of rising oil prices is not homogeneous across the economy. Other industries must struggle to make up for narrowing margins as oil prices rise. The problem is not oil prices themselves, but the additive effect that they have on other products. This is the key reason why uncertainty in oil future causes uncertainty in many other parts of the economy as well.

Since 2004 when oil prices began to rise, oil futures demonstrated uncertainty. The problem is not that they rose, but that they are expected to remain high for quite some time (Federal Reserve, 2004). In retrospect, these oil investors were correct and oil prices rose to levels that were not even imagined. No one can predict the future, but the beliefs of the investors plays an important role in the mount of uncertainty that is reflected in the economy. In 2004 investors expected prices to decline from their current levels, but to still maintain a higher level than they were prior to the rise (Federal Reserve, 2004). It is not what oil prices actually do that is the key factor in economic uncertainty, but the expectations of what they will do that is important from the perspective of the financial markets (Kilian, 2007).

Supply and Demand

Generally, prices are a reflection of the balance between oil supply and oil demand. Basic economic principle states that when supply is high, prices are relatively low. Conversely, when the demand outpaces the supply, prices rise. The recent rise in oil prices would theoretically reflect a state where high and rising prices reflect rising demand. According to the International Energy Agency (IEA), global consumption is expected to continue to rise sharply in the near future (Federal Reserve, 2004). Oil consumption in Asia and Chins still lags behind that of the United States, but Asia cannot be discounted as a source of rising demand. As Asia, particularly China, become more industrialized oil demand continues to rise. Emerging markets, such as these, are now major contributors to crude oil demand on a global basis (Federal Reserve, 2004). The individual countries might not represent that much of an increase individually, but collectively their impact is substantial.

The demand side of the equation spins out of control on its own. However, the same cannot be said for the supply side of the equation. On the supply side, oil production has been limited by several factors. The first is geography. Exploratory drilling is expensive and might not always result in a significant find. Oil is only available and accessible in a limited number of locations. Geopolitical issues also limit production in several areas. Oil prices can be controlled somewhat be limiting production at drilling and crude oil processing facilities (Federal Reserve, 2004. Supply can be controlled somewhat by production agreements with the Organization of Petroleum Exporting Countries (OPEC). When supply is low compared to demand, OPEC can decide to pump more oil to make certain that the demand is met (Kaufman, et al., 2007).

Controlling the supply can also be used as a price control mechanism. For instance, OPEC might cut production in order to lower the supply available to meet demand. This would cause an artificial price adjustment and rise in oil price, even though there is no need for it. This is often looked down upon by a majority of the world. However, OPEC is one of the largest oil producing conglomerates in the world. There are other countries that have a small domestic supply, but they cannot meet the demand as easily as the Middle East (Kaufman, et al., 2000). Until a replacement supply can be found that adequately can replace that which is supplied by OPEC, the world will be subject to these artificial price fluctuations.

Source: Williams (2005).

The only reason that OPEC can get away with controlling supply to manipulate price is that oil is such a basic commodity that no one can live without it. There are several substitute products that are still in the experimental stage, such as methane, biofuels, and other replacement fuels. However, at the current time, these are not being produced in a quantity that is sufficient to replace the needed oil altogether. Therefore, the world is still highly dependent upon oil and it appears that it will be for quite some time. With substitute products far down the horizon, the world will continue to depend on oil for a long time into the future.

Aside from limits on capacity as a contributing factor to volatility in oil prices, there are other external factors that can affect supply as well. The political situation in the Middle East is extremely volatile. The political situation in the Middle East can have a dramatic impact on oil supplies. However, threats to the oil supply are beginning to emerge outside of the region as well. For instance, there are political situation beginning to arise in Russia, Venezuela, and Nigeria (Federal Reserve, 2004). Political instability can disrupt the supply of oil from a particular region.

Weather can also take a toll on the production and distribution of oil and oil products. For instance, hurricane Katrina disrupted oil production in the Gulf of Mexico. This caused a temporary shortage until the services could be restored. There are other external factors that can effect oil prices that are beyond the control of the companies.

Oil futures represent clamed to oil to be delivered at a specified price and at a specified date and location. If the price of oil rises above the price specified on the contract, the purchaser will be able to sell their claims to the oil at a profit. Buying oil futures requires a high degree of speculation on the part of the futures broker. The general consensus among speculators is that oil shortages will worsen in the future as demand continues to climb.

There is also room for artificial manipulation on the part of oil speculators. It oil futures are high, than oil producers will hold back oil from today's market, waiting for a better time to buy (Federal Reserve, 2004). When oil speculators hold back waiting for higher prices in the future, it causes an artificial drop in supply. This is another way in which companies can manipulate oil prices. When speculators hold back massive quantities for future purchase, it creases a temporary shortage in supply (Federal Reserve, 2004). This is a key reason for spikes in oil prices. The oil needed to meet demand is available, but it is not being released. Investors are not concerned about temporary spikes due to anticipated high futures prices.

Spikes in price are a key disadvantage in oil speculation and cause the practice to have a negative connotation (Harrison, 2006). Oil Speculators are often blamed for oil prices, when in fact the rise stems from another factor. However, oil speculation has one positive benefit. It assures that there is a future supply of oil available should natural disruptions in the supply occur (Federal Reserve, 2004). Oil speculation can boost current production of oil, as producers attempt to fill the temporary shortages and receive a premium price for their product (Harrison, 2006). Oil speculation assures that there will be a supply available when it is needed.

One of the difficulties that the layman has is how to determine whether the rise in price is temporary or long-term. There are several key indicators that can help to determine if a spike in price is the result of speculation or whether it represents a downward trend. The first way to determine if prices are a speculative move is if the daily oil price is highly reactive to news about future supply and demand. A second indicator that an oil price rise is the result of speculative training is that we should see speculative traders holding large amounts of oil for future delivery (Federal Reserve, 2004). This information is not always readily available to the general public. A third indicator that a rise in oil price is due to speculation is the accumulation of significant increases in inventory being held for future use (Federal Reserve, 2004). When one begins to see these three conditions being met, then a rise in price is more likely to be speculative and represents s short-term rise that will come back down quickly.

However, if one begins to see a rise in oil prices without the presence of inventory build up, then it may be that this represents a more permanent rise in oil prices (Kilian, Revucci, and Spatafora, 2007). It may mean a new high for oil prices that will be sustainable in the future. Historical data is usually used to determine if surpluses are being held for the future (Federal Reserve, 2004). Decreases or increases from the previous year are a good indicator as to the direction that futures prices will take. However, this method is not perfect, unless one takes into account rises in demand into the equation.

Inflationary Adjustments in Oil Prices

Aside from supply and demand, oil also adjusts just like any other commodity in relation to inflationary forces. Inflationary rises are often difficult to spot because they happen more slowly. They are more gradual than spikes caused by futures speculation. One of the key indications that a rise in oil price is the result of inflation that oil prices are rising at the sale rate as other commodities. Oil prices typically adjust more quickly than other commodities. Therefore, adjustments in monetary policy will first show up in commodities that adjust more rapidly to changes in monetary policy (Federal Reserve, 2004). However, many analysts do not find oil prices to be a reliable instrument for setting monetary policy (Federal Reserve, 2004).

Using oil prices to set monetary policies would work if oil prices reacted reliably to adjustments in inflation. However, there are many other factors that can effect oil prices, such as geopolitical upheaval, the weather and other less predictable factors. Therefore the consensus is that oil prices can be affected by inflation, but that this is not a reliable means to determine the direction of oil prices in the future. When a certain commodity rises more rapidly than other commodities, it is more likely to be a temporary rise in price (Federal Reserve, 2004).The commodity that overshoots the inflationary index will be more likely to adjust back down to levels that are more in line with other commodities. However, before one uses this as a rule to determine if the current rise in oil prices is temporary or long-term, it is important to consider the complexities of the oil market. One must determine if other factors are at play in the high prices.

Determining the Best Method for Predicting Oil Prices

This research discussed the complexities of the oil market and examined three factors that can help to predict future trends. In this analysis, no single factor emerged as the best way to predict oil prices in the future. All of these factors help to determine oil prices. It is important to understand that they work in conjunction with one another. To complicate matters further, any one or a combination of these factors can emerge as the predominant factor in any trend. For instance, if OPEC decides to cut production and all other factors are in balance, then supply decisions by OPEC take precedence over the other factors. However, inflationary forces, as well as speculative forces might also be working together to produce a particular trend.

Currently, oil prices are at a historically high trend that has been building for approximately three years. This represents a long-term trend, rather than a temporary spike. However, the most important question is not what oil prices have done to reach this new high, but rather whether they will stay at this level for the long haul. The question weighing on everyone's mind is whether they will continue to climb higher. If they do climb higher they will begin to have a negative impact on the economy, particularly that of the United States. The United States and other highly industrialized nations are more susceptible to economic turmoil due to high oil prices than non-industrialized nations. Oil is more highly imbedded in the economies of industrialized nations as it is used the transportation that is necessary to make the economy function.

As far as future demand is concerned, it is likely that the demand for oil will continue to rise on a global level. As an increasing number of industrialized nations rises to the ranks of industrialized nations, their dependence on oil will increase as well. This will have a significant impact on the demand for oil in the future.

Oil usage differs among industrialized nations. For example, Japan uses almost one-third the amount of oil as the United States (Federal Reserve, 2004). There are also differences in the efficiencies with which nations use their oil reserves. For instance, Chinas uses its oil much less efficiently than other nations. This partly due to the underdeveloped electrical grid in China and their heavy dependency on diesel powered generators (Federal Reserve, 2004). China is a recent player as far as industrialized nations are concerned. However, they will continue to develop their grid and improve in their usage of natural resources. Energy demand will increase, but so will the efficient use of China's resources.