When a person launches an economic commentary site, I can assure you they are a curious breed! The desire to understand the “why” behind things, and prepare for the future, boils down to extreme curiosity.

The inquisitive will not be stopped in their quest, and people of this ilk demand sensible answers.

So naturally, when retail gasoline prices spiked 62.7% since December 29, 2008, amidst a severe recession, I wanted to know why. Put another way, average U.S. prices at the pump have increased more than a dollar per gallon. Intuitively, we know this isn’t a positive event for economic recovery. But some say the increase in gasoline demand, and thus the price, is an indicator of economic recovery. (1)

Unemployment continues to rise (9.4% nationally in May); another wave of foreclosures is surely on the horizon due to joblessness and adjustable rate mortgage increases, thus making a stabilized housing sector unlikely; food is getting more expensive; and real GDP declined -5.7% in the first quarter. Combine all of that with rising Treasury rates, thus rising credit card and mortgage rates, and it’s safe to say that the 62.7% hike in gas prices isn’t entirely due to economic recovery.

When it comes to oil, everyone who is engaged in economic discussions generally adopts one of the following go-to rationales: 1) supply and demand drive oil prices toward the long-run equilibrium or 2) evil speculators manipulate oil markets, spuriously driving up prices.

Rather than take one side because it sits better with me, and find data to support that position, I took on the novel task of researching information, and then coming to a conclusion.

We know oil is not a free market, but what is these days? OPEC controls 66% of the world’s oil reserves, and 33% of the world’s oil production. I have always tended to lean towards supply and demand as the principal driver of oil prices. The reason for this is supply and demand drives every other market, and my knowledge of futures speculation is admittedly relatively limited.

How culpable are speculators to this mess? In a society bent on finding scapegoats, let’s begin with speculators, the most favored scapegoat of all for expensive oil.

The first step was to construct a graph, comparing the barrel spot price of oil to the U.S. average retail pump price. More specifically, comparing the percentage change in the prices from when the first significant run up of oil began, in 2007. As it turns out, oil bottomed out into the low $50/barrel range in January of 2007, before it soared to record highs. By seeing how much retail pump and barrel prices increased from the baseline date of January 1, 2007, we’ll see, to what extent, oil speculators drive the price of retail gas. (2)

The story of evil speculators goes like this: they purchase oil futures, contracts to buy oil they never intend on actually receiving, artificially driving up demand for oil. They sell the futures right at the top of the market, getting out in time with bundles of profits. Meanwhile, petroleum executives at BP, Chevron, ConocoPhillips, ExxonMobil, etc., call up their retail chain outlets and order them to raise prices at the pump accordingly, in concert with the spike of barrel prices.

Let’s see what the chart has to say:

There are brief moments, such as March ’07 to June ’07, and January ’09 to March ’09, when gasoline prices rise faster than the underlying barrel prices. Or, the red line is higher than the blue line. But for the most part, retail pump prices have lagged well behind barrel prices. Throughout the initial run up of oil from January ’07 to the end of July ’08, and the current run starting December 29, 2008, retail gas prices have grown at a much slower rate than barrel prices. Where the graph doesn’t explain why prices rise or fall, it does show that, overall, petroleum companies are not hiking retail pump prices anywhere close to the same rate as the cost of the barrels they produce or purchase. This significantly discredits the argument that oil speculators, and capitalizing petroleum execs, drive retail pump prices in a meaningful way.

What about supply and demand? The Energy Information Administration reports that crude inventories fell last week by 3.9 million barrels, or 1.1%, and have dropped 10.8 million barrels over the last four weeks. So, the oil-producing countries making up OPEC have cut supply. Meanwhile, four-week gasoline demand was up 1.14%. Some credit this to the beginning of summer driving season, others to economic recovery; but irrefutably, people are driving more. The other wrinkle to retail gasoline supply are the refineries. Reports say that refineries miscalculated the increase in summer driving demand. (2)

I’m willing to accept the recent 62.7% increase in retail gas prices (and initial run up starting January ’07) as, principally, a supply and demand phenomenon; but let’s not confuse OPEC-driven and refinery miscalculated supply, timed perfectly when all parties knew driving demand would increase some amount over the summer, with a legitimate marketplace. And as the graph above indicates, there are blips when speculators seem to be driving up prices faster than the cost of the barrels. Both futures traders, and supply and demand, cause price fluctuations, but it appears supply and demand rules the roost.

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(1) Energy Information Administration – Weekly Retail Gasoline and Diesel Prices

http://tonto.eia.doe.gov/dnav/pet/pet_pri_gnd_a_epmr_pte_cpgal_w.htm

(2) Energy Information Administration – Crude Oil Spot Prices

http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_d.htm