Crude oil futures and gasoline prices over the last week have experienced a phenomenon that we have not seen since last September: a decline. Lower oil prices have been driven by higher inventories, appreciation of the U.S. dollar, and slower global economic growth projections. Although gasoline prices reached close to $4 per gallon on average across the United States, lower oil prices and a decline in the quantity of gasoline demanded has helped to put downward pressure on gasoline prices. In addition to these supply and demand issues, expectations by speculators of supply disruptions in the future from Libya and other issues in the oil rich Arab region have subsided for now. With these issues bringing about volatile oil and gasoline markets, the question remains: Where is the price of gasoline heading?
In a previous PolicyMic article, I outlined my research on forecasting gasoline prices using the price of crude oil futures. Since December 2010, there has been a clear diversion from the typical relationship of these two prices, where gasoline prices have risen much faster than what the increase price of crude oil futures can explain. Numerous explanations for this are possible, but increased liquidity into the markets by the Federal Reserve and oil supply disruptions in North Africa and the Middle East top the list.
The oil that is typically refined into gasoline is light sweet crude, which is drilled in Libya and not oil that is produced in places like Saudi Arabia. Considering that Libya holds only 2 percent of world oil supply, it should not have a substantial impact on oil prices; but since its oil is used to produce gasoline, the reduction of the light sweet crude has had a much larger impact on the refining process of gasoline. In addition, much of this oil is used in Europe and Britain; therefore, their supply of oil to be refined into gasoline has been significantly distorted and this has had an impact on oil prices and on the supply of sweet crude oil to be refined into gas. The rebels who now control the Libyan oil production facilities in the eastern part of the country have stated that they will stop production for another month, further reducing the supply of this light sweet crude oil.
The national gas price average last week was $3.965 and has been falling precipitously since that time. Oil prices are now closer to $100 per barrel instead of the $110 per barrel seen just last week. If this reduction in oil price futures remains at the current level, there could be a $.20 to $.25 reduction in gasoline prices over the next week or two.
The question will be whether price of crude oil futures will remain at the current level. Once oil production in Libya begins again, we should expect gasoline prices to fall further. My model shows that gas prices should be closer to $3.20 with the past relationship between oil price futures and gasoline prices. Therefore, I conclude that the $.765 gas price premium has been priced in from other events around the globe, or it may be that the relationship has changed.
Politicians have started to resort to the populist message of “taking it to” the oil companies and have looked to reduce their tax breaks. As stated in a previous PolicyMic article, I believe that all tax breaks and subsidies should be removed on all energy sources, but targeting only the oil companies is misguided. The cost of such an action will be higher gasoline prices at the pump and further distortions in the energy market, as subsidies will continue to be given to other energy sources.
The markets will work themselves out if left to their own devices. This is being shown in the current situation as oil and gasoline prices were apparently overpriced relative to the supply and demand components and have started to reach back to a lower equilibrium. The excitement of energy prices is that there are always events that can alter the markets and the direction of these prices are highly volatile. With the lack of domestic production of oil and increased refining capacity, we can expect that in the short term, prices may be lower; but long term, prices will be higher without a change in our misguided energy policies.
Photo Credit: Vance Ginn