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HICKS: Gas prices explained by simple economics

May 14, 2011

For those of us with pickup trucks, the past few months have been a startling reminder of our dependence on gasoline. I think it is time to write a bit about what drives gas prices and why they are so high.

Of course, the gas price at the pump is set by the guy who owns the gas station. The owners are free to sell their gas for as little or as much as they wish. The problem is that most of them want to stay in business, and so will set a price that reflects the local market for gasoline. But, in reality, most of us aren’t too worried about a few-pennies-a-gallon difference between stations. It is the dollar-per-gallon difference since January that matters to us. Here, the story is a bit longer, but it is still about markets.

The change to a price of gasoline is almost wholly driven by the change in the price of oil. The reports we hear each day about the price of a barrel of oil is the futures price set on the commodities markets. This price is set by buyers and sellers who are trying to reduce the risk of price fluctuations on their companies. So, they may be oil producers, oil buyers, brokers, and buyers and sellers of other related commodities.

In short, the commodities market is made up of thousands of buyers and sellers. Every time gas prices go up, some audacious attorney general embarks upon another fruitless investigation into speculation and price fixing. The problem is that no matter how high or low these prices go, for every sale there is a buyer who thinks prices will rise and a seller who anticipates their decline. It is fundamental economics that drives gas price changes, and that is far more worrisome than speculation.

Oil prices are affected by the demand for petroleum products, the available supply of oil, the value of the currency in which it is denominated, and uncertainty about future supply or demand. So, to place the current prices into context, the world economy is recovering, so worldwide demand for oil is rising. The recession and some domestic policy dampened new exploration for oil, and new petroleum infrastructure. This limits supply.

So, with higher demand and a lower supply, prices rise. International uncertainty plays a factor, though the largest oil exporters are largely unaffected.

The real problem for Americans is that the value of our currency has been declining significantly. So, the cost of oil in dollars will necessarily rise to accommodate that decline. We are to blame for the slide of the dollar and this should serve as a timely reminder that the stimulus package and the two rounds of quantitative easing were not a free lunch.

Some good can come from this. We should all applaud President Obama’s calls for ending subsidies to oil companies, or any energy producers for that matter. Just don’t expect it to change prices at the pump.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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