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VOICES FROM THE INDUSTRY: High gasoline prices sometimes difficult to understand

September 25, 2006

Just who or what is it that sets the price for a gallon of gas? Well, gasoline station owners of course. Whether it's a momand-pop station or part of a large chain, the owner looks at prices up and down the street and changes the signs accordingly. These owners know what everybody else around them is charging, and they also know what their supplier is charging them for their wholesale supply.

What about the wholesale price? Its set in a similar fashion, only wholesalers not only look at competitors, but also the spot price. The spot price is basically set by supply and demand. A refinery blows up, supply gets constrained, and the price goes up.

Some analysts say that the price of gas is set by accident. It's the sort of thing where no one party is really responsible, but everyone contributes. You, for example, can look in the mirror, because your demand for gasoline is part of what deter mines the price. So, if you didn't drive the big SUV and consume so darn much of the stuff, then it wouldn't be so expensive.

Big oil supply

But demand is only part of the equation. How about supply? One hypothesis making the rounds is that oil prices are going up now because we are running out of oil. Well that is just not true. Let me explain, BP's latest annual energy review of known global oil reserves actually went up last year. So despite all the oil used last year, we still have a higher global reserve.

We use more oil today than we did in 1980, and the consumption rate in 1980 was about 29.6 years of supply. In 2005 consumption rates, we have a global supply of approximately 40.6 years. So we have a larger cushion even at the current consumption rate today than we did in 1980.

Proven reserves now stand at 1,194 billion barrels, according to the June BP Statistical Review of World Energy. In the mid-1980s, that reserve stood at 1,027 billion barrels. Is that possible? Of course, the oil companies are better at finding oil and use better technology today. Crude oil inventories in the United States are higher today than in 1998 when oil was around $12 a barrel instead of the $64-plus it was selling for in mid-September.

The fear factor

At this point you may be asking, Paul, if supply and demand isn't driving up our fuel price what is? My answer is still two words, fear and greed. Fear is actually a risk premium being built into the price.

Prices are higher today because we're afraid, and by being afraid we speculate that we may be vulnerable. What if there's civil unrest in Nigeria? What if there's a revolution in Venezuela? What if Iran does something stupid?

I like to keep a proper perspective on things by looking at history. Sure there is a nut running Iran, but hasn't that always been the case. Is the world more dangerous than in 1979 during the Iranian revolution? Is oil production at risk any more today than it was in the 1988-89 Iran-Iraq war? Has Nigeria ever been a peaceful place? Not in my lifetime.

Now what about the greed part of the equation? Yes, OPEC does constrain supply to some extent and the big oil companies are making more money than ever before. But they have been careful not to push the global economy over a cliff. That is not in its long-term interest. Of course it is a fine line between making as much money as you can and still keeping prices at a level where non-OPEC countries won't decide to drastically expand their production. This would affect the bottom line of OPEC countries.

Look at it this way. When President Bush first took office six years ago, the average price of a gallon of gas was a buck-thirty. Now, that same dollar-thirty will fetch you half-gallon. So what gives? The supply is actually outpacing demand, while the world is still a frightening place, but no more than usual.

Since 2003, the physical market has grown by 8 percent while the open interest on the commodities exchange has grown by 110 percent-in part because hedge funds are getting more interested in this market and simply chasing a trend. They're buying because it's going up and it's going up because they are buying it. Sounds like the same loop as technology in the late 1990s.

Some would say that the fear premium has added at least $30 a barrel to oil prices. Is this sustainable? My short answer is, of course not. So you don't have to go out and sell your Hummer just yet. Prices were bound to go down at some point.



Coan is managing partner of Indianapolis-based Wealth Planning & Management LLC. Views expressed here are the writer's.
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