Anyone who has ever filled up gas (or driven by a gas station… or followed the news) can tell you that prices tend to change unpredictably. So, why does the price of gas change so wildly?
As of 2012, 66% of the price of gasoline comes from the price of oil. The other determinants of gas price (taxes, refining, marketing) remain relatively constant, so we can go ahead and assume that gas prices are most affected by oil prices. Comparing oil and gas prices over time, the close correlation between the two is evident:
It’s clear that oil and gas prices are closely related, but why are they fluctuating so wildly? Seeing as gas prices are based on oil prices, we must delve further into the movements of oil prices.
Basic economic theory tells us that price movements are caused by changes in supply or demand, so let’s look at a graph of global petroleum consumption (which we can equate with demand) & supply compared to oil prices.
Consumption and supply have remained constant over the last 9 years, while crude oil prices have wildly fluctuated. The maintenance of huge oil reserves ensures a constant supply of oil regardless of any geo-political events. With consistent supply and demand, the only explanation for price changes can be external market shocks, which can include political instability in the Middle East or extreme weather like the abnormally cold winter this year.
But how do tensions in Syria or Crimea translate to higher prices at the pump?
At the core, this issue is centered around oil futures. Oil is a commodity, and duly traded in the commodity markets, which ultimately determine the price of a barrel of oil. People typically lock in sales of commodities using futures. Futures contracts were originally created to allow sellers/buyers to lock in prices for commodities they would sell/buy in the future, eliminating fears of future price changes and making the market more stable. Futures are what we know as a derivative--the price of them is derived from the price of the underlying good (oil)--and they are traded in a market which determines their price.
As most investors know, markets & prices fluctuate wildly based on the slightest hint of trouble (read: investor speculation). The existence of a commodities market would not negatively impact prices if it was only filled with people actually trying to buy commodities. However, investors immediately saw this as a way to make money (don’t they always?), and entered the commodities market to take “bets” on the prices of commodities changing & reduce risk. That is where our problem develops--the entrance of speculation into the oil market.
The difference between speculative and non-speculative investors comes down to contract completion (or a lack thereof).
A traditional (legitimate) futures use case is characterized by the contract maturing to completion:
Starbucks needs to ensure it will have enough coffee beans for all of its stores. They buy 1 year futures contracts at $25 (meaning, in a year they will pay $25 for a set amount of coffee beans and receive that amount, regardless of what the current price may be). After a year, the market price of coffee is $26. Starbucks isn’t worried about the increase in coffee bean prices, because they already have a set price. When the contract matures, they will receive the same amount of beans for $25 that a current investor would receive for $26. Success!
In a speculative futures use case, the contract will not mature to completion:
A bank believes that coffee prices are going to increase in the next year due to a virus wiping out crops. They buy long coffee futures (bets that the price will increase) for $25. Six months later, the market price for coffee is $30. The bank senses the smell of profit in the air, and sells their futures before they mature—after all, what use do they have for physical tons of coffee beans?
Speculative investors typically avoid having to physically acquire the commodity by pairing their futures contracts (buying one long & one short) to offset each other or selling their contract before it reaches maturity. This is all good & dandy, except for the fact that speculative investment affects the prices the legitimate buyers will pay.
As within any market, the cost of futures contracts fluctuates in tandem with how many people are trying to buy them. When there is lots of demand for long futures (bets that the price of oil will increase) by investors, the spot price (current price for futures) will increase, making the legitimate purchasers of oil pay more than they would have otherwise.
What affects this demand for futures bets? Well, that's where Crimea and Syria come in (as well as any other geopolitical events). As investors see global events unfolding, they sell or buy futures for price changes in accordance with their forecasts. So an investor witnessing the Crimea/Ukraine/Russia tensions might buy long futures (bet on price increase) because they believe these tensions will limit the supply of petroleum due to the voluminous pipelines located in that area.
The extra money consumers pay due to speculative activity is known as a "speculative premium". How much more money are we talking? Let’s put a number to it:
While these numbers are purely speculative, they tell an interesting story about the connection between what are essentially "bets" on price changes and how much you pay at the pump. The nature of commodities price determination (market-based) means that investor demand can change prices--unfortunately, that includes investors who do not actually want to buy the oil, but instead profit. Despite some critics best efforts to regulate the amount of speculation allowed in commodities markets, for the time being this market isn't going anywhere. The Commodities Futures Trading Commission (CFTC) continues to petition for speculative position limits, which would aim to curb the amount of speculation while allowing a sufficient amount to provide market liquidity. Only time will tell if these efforts will successfully translate to lower prices at the pump, but my wallet is sure praying they will!
Gas prices change as the price of oil changes. The price of oil is determined in the commodities market. Futures contracts help suppliers/buyers get good prices for oil in the future, but speculative investors use them to take bets on price changes based on geopolitical events. This drives oil prices up. As more and more speculative investors enter the market, the "speculative premium" consumers pay at the pump increases.