ECONOMIC ANALYSIS: Speculators aren't to blame for pain at the gas pump

August 4, 2008

Speculators are blamed for a number of bad things-lately, even high gas prices. It is fun to find villains. In fact, casting blame has replaced baseball this summer as the official sport of Congress. But it might do some good for the soul to ask just who these speculators are, and how they might affect gasoline prices.

To begin with, it is worth understanding that the price of gasoline is largely determined by the price of oil today. Refinery capacity, taxes, regional environmental regulation, local cost of living and short-run demand play lesser roles. Gasoline is sold only on "spot" markets. That is the price you pay at the pump. Petroleum is sold both in spot and "futures" markets. It is futures markets where speculators live.

Futures markets exist because producers and consumers often have sought ways to reduce the risk associated with future price fluctuations in commodities. This reduction in risk translates into greater profits.

The mechanisms of futures markets are simple. People who produce oil and people who buy it don't know what the price will be in the future. The futures markets allow buyers and sellers to bid to a price for oil delivered at some future date. Like all markets, it is an auction of sorts. The futures price then serves as a contract to either buy or sell a quantity of oil at that price on the date specified. The futures price may be much different from the spot price, which is determined by today's supply and demand. One result of futures markets is that oil prices are less volatile because of them.

Like any market, the number of buyers in a futures market affects price. In the past year or so, there have been lots more buyers. This is true for all commodities, not just oil. The reason for this should be painfully obvious to anyone who opened their retirement fund account from the last quarter. The big drop in the stock market is driving investors to commodities (like gold, silver, oil and corn).

To be clear, these new investors are buying futures on oil to make money, just as the old investors were. Thus, the definition of speculator is someone who has recently decided to make money in the petroleum markets. That is at least the definition Congress is working with this summer.

Now, lots of readers will be unhappy with my cavalier dismissal of speculation in the face of high gasoline prices. Gas prices are indeed high, and my new (very inexpensive) pickup truck and I feel your pain. But the futures price of petroleum isn't what drives gasoline prices. Gasoline is sold in spot markets with very high inventory costs. So, you cannot hold onto gas today until there's a higher future price. The price of gasoline at the pump is set by supply and demand today, not in the future.

So, we-and our pickup trucks-are more to blame for high gas prices than are those supposedly villainous speculators.

Hicks is director of the Bureau of Business Research at Ball State University His column appears weekly. He can be reached at bbr@bsu.edu.
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