The Paradox at the Pump

If oil prices are rising, why are gas prices falling?

Investors, traders, and American drivers are puzzled by a seeming paradox: The price of gas in the United States has been falling in recent weeks even as the price of crude oil has rocketed to historic highs. The two charts on the upper left-hand side of the Energy Information Administration’s latest edition of This Week in Petroleum illustrate the conundrum. The price of a barrel of crude has been flirting with $50 while retail gas prices have dropped 19 cents from the record $2.06 per gallon price of early summer.

The diverging charts seem to defy rational explanation. If the price of the main input (crude oil) of a product (gasoline) is rising very rapidly, you’d expect the price of the product to rise, unless actors at different stages of the supply chain (refiners, distributors, gas station owners) decide to accept reduced profits. But it turns out the explanation for the dichotomy lies in the more or less rational functioning of markets.

The price of crude oil is measured by the trading of futures contracts on the delivery of oil next month at the New York Mercantile Exchange. (Here’s the description of trading in light, sweet crude.) Companies use these futures to hedge their exposure to oil, and investors use them to speculate. In the past year, amid concerns about terrorism, questions about China-fueled demand growth, and instability in centers of oil production ranging from Russia to Iraq and Venezuela, the volume of trading in such oil futures contracts has risen sharply.

The rising asset prices have encouraged investors to pile in. Hedge funds and the proprietary trading desks of huge investment bankers, which have historically been small players on the New York Merc, are now crowding into the market. “Like any speculative market, this one is strongly affected by liquidity, volatility and demand—and all of those elements have increased sharply in the past year,” Gregory Zuckerman and Henny Sender wrote Monday in a Wall Street Journal front-page article on hedge-fund activity in the oil markets. Last week, they report, hedge funds accounted for about 28 percent of long positions in crude oil at the New York Merc, up from about 13 percent in 2002.

The presence of active, deep-pocketed marginal buyers, many of them comparatively new to the marketplace, can move prices up and down rapidly, frequently without regard to marketplace fundamentals—thus spiking crude prices. While crude oil futures are up about 45 percent so far this year, energy stocks haven’t risen as much, which means investors in oil stocks don’t believe the prices reflected in oil futures will last long.

So, the logic of the futures market helps explain the rise of crude oil prices. The logic of the overall market helps explain the fall in consumer gasoline prices.

The American supplies of both crude oil and refined gasoline have increased in recent months. U.S. stocks of crude oil stood at 293 million barrels on Aug. 13, up 5 percent from a year ago. Crude doesn’t go directly into gas pumps. It is processed, distributed, and delivered. And bottlenecks, deficiencies, or breakdowns in the supply chain—a ruptured pipeline, a shuttered refinery—can cause prices at the pump to rise. The converse holds true. If U.S. refiners are turning more crude into gas and maintaining greater inventories of refined product, that could help keep a lid on retail prices.

And that’s precisely what has happened. This spring, gasoline inventories were below average. But as gas prices rose at the pump, the EIA reports, refiners increased production to exploit the high prices. Importantly, they continued to refine gasoline at high levels in July, a period when capacity is frequently deployed to get ready for the heating oil season. As a result, as this data shows, total U.S. gas supplies on Aug. 13 were 205.7 million barrels, up 4.5 percent from a year ago.

Even as supplies have risen, demand for gasoline has slowed markedly. In the early part of 2004, year-over-year gasoline consumption was up by almost 3 percent, according to Jonathan Cogan, energy information specialist at the EIA. But as gas grew more expensive, individuals drove less, car-pooled, and started shopping for Priuses instead of Hummers. Businesses figured out ways to use less gas by, for example, shipping goods by rail instead of by truck. As a result, EIA reported, the four-week average of gas consumption for the week ending Aug. 13 was 9.392 million barrels, essentially unchanged from the year before. “Through the first 225 days of 2004 compared with 2003, gasoline consumption is only up 1.9 percent,” Cogan notes. With supply up and demand flat, it’s no surprise that gas prices have been falling.