What Mr. Dorgan probably meant was that the pump price of gasoline is not being determined by the current production and consumption of gasoline. He suggests that the price has been driven up by “excess speculation” in commodity markets. To this end, he is suggesting that regulators “ensure that the price of gasoline reflects the fundamentals of supply and demand”.
Today’s lesson, for Senator Dorgan and politicians everywhere, is about the fundamentals of supply and demand, and the role of speculators.
Part I: Supply depends on the availability of raw materials and the costs of production. When politicians block the construction of pipelines, they increase the cost of moving oil from the point of origin to the refineries. When they ban drilling for oil, they prevent new supplies from holding down prices. When they don’t authorize the construction of new refineries, they prevent supply from increasing.
Part II: Commodity futures markets are all about speculation. Futures markets exist due to the uncertainty of future spot prices. (A spot price refers to the price for immediate delivery). If the price of a commodity was known for certain, there would be no benefit to contracting for future delivery, and all bets on future values would have no payoff. The uncertainty surrounding future prices creates a market for hedging and a market for speculators.
Hedgers buy and sell commodities for future delivery to reduce their risk. Speculators are betting that current spot process and future spot prices will be different and they “bet” accordingly. Without speculators willing to take on the risk, hedgers may not be able to reduce their risk.
When prices are expected to rise, current demand will increase, current supply will decrease and current price will rise. If my new sources are even remotely accurate, Iran is enriching uranium in an effort to produce nuclear weapons. Most of the rest of the world condemns Iran and has placed embargos on Iranian oil. Israel wants to blow up Iranian research centers and Iran has threatened to blockade the Straits of Hormuz. A large portion of the world’s oil passes through that body of water.
If Iran closes the Straits, the spot price of oil will certainly rise. Since there is a positive probability of that happening, expected prices for crude oil in the future are rising. Higher future oil prices cause higher current oil prices. Higher crude prices mean higher gasoline prices.
Part III: For speculators to make a profit, they have to be correct on average. If the price of oil is not going to rise, speculating that it will rise results in losses. Speculators cannot, by themselves, drive up spot prices and keep them there long enough to liquidate their positions. Anyone that doubts that should ask the Hunt Brothers who tried to corner the silver market in the late 1970’s and watched their fortune evaporate in 1980.
Gasoline prices are high because demand has been increasing faster than supply. More cars, more planes, more electricity, fewer drilling permits, no new pipeline, no new refineries. Oil prices are rising due to uncertainty in the Gulf. It’s all about supply and demand.
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