What’s really driving gasoline prices

The sharp rise in gasoline prices is causing a lot of concern for folks right now, and with good reason.  Gas prices are up about 35% from one year ago, and these increases pinch working families directly at the gas pump, and indirectly through higher prices in groceries and other products.

As always happens when gas prices rise, the party not holding the Presidency knows exactly whose fault it is — it’s the President’s fault!  The fact of the matter is that it isn’t true, no matter which party is in charge of the White House.  Democrats have been just as guilty of scapegoating Republican Presidents on this issue.

The President, in fact, has little control over what happens to gas prices, and we should ignore the every-four-year political sideshow that blasts them for not doing something about it.  Let’s first talk about the things that politicians say are increasing gasoline costs, but aren’t.

Myth:  Obama’s lack of activity to increase domestic oil production is increasing gasoline prices.

The reality is much more complicated.  The fact of the matter is that if Barack Obama had unilaterally opened up oil production in the Gulf of Mexico, in the Alaska National Wildlife Refuge, and in the intermountain west on January 20, 2009, we would barely be seeing a drop of that oil in the market today.  It literally takes years just to go through the land sectioning and contracting process to allow private companies to drill in offshore areas and on public lands.  And, that doesn’t count the fact that there are no offshore drilling platforms sitting around idle just waiting to be moved into production.

The link between domestic oil production (which accounts for less than half of our consumption) and gasoline prices is tenuous anyways.  At the height of concerns about domestic oil production — during last year’s Deepwater Horizon explosion and oil leak fiasco — the price of crude oil and gasoline both fell (crude by 9% and gasoline by 5%), and this was as peak driving season shifted into gear (April to July).  Conservative dogma would tell you that the increased demand plus the loss of the Horizon oil plus the restrictions placed on further offshore drilling should have spiked prices, but it didn’t.  There must be other forces at work, and there are.

Myth:  Obama’s military intervention in Libya is the cause of the spikes

Libya represents about 2% of OPEC’s oil output, or about 0.7% of the world’s oil output.  And while unrest there has essentially stopped the flow of oil from Libya, OPEC has filled the gap from its other member countries so there has been no net loss in world supply.

And, the spike in gas prices began long before Obama entered the United States into military action in Libya in mid-March.  The fastest rise in gas prices can be tied to the February peak of the Egypt crisis.

Reality:  Gasoline prices today are heavily linked to the impact of financial speculators in the crude oil market

Since 2000, large financial services firms have adopted crude oil as a commodity to be traded just like any stock, betting on the highs and lows to make a profit.  Before 2000, only about one-third of crude oil future transactions were made by these speculative traders — today, three-fourths of all crude oil future transactions are speculative in nature.   The number of speculation contracts has increased 64% since 2008 alone.  Traders today hold over 260 million barrels of oil under futures contracts, a historically high level.

And, oil speculation has proven to be very profitable for firms like Morgan Stanley and Goldman Sachs.  Goldman, for instance, made $5 billion in profits from oil (and other commodity trading) in 2009.

Goldman Sachs, incidentally, recently advised its oil investors to get out now.  Why?  Record speculation.    Using Goldman estimates and U.S. Commodity Futures Trading Commission numbers, fully $26.75 of the cost of a barrel of crude oil can be tied to speculation.  That’s about one-fourth of the current price of a barrel of oil, and if you take the corresponding increase out of gasoline prices, then there’s not really any significant increase in gas prices.

What’s wrong with speculation?

Some people have the notion that speculation is always bad.  It isn’t.  Speculation has very real and valid purposes, of course.  Our stock market is, in part, built on speculation.  But there’s a very real difference between a speculator and an investor.  An investor is worried about whether or not an investment — in this case, the commodity of crude oil — is fairly priced.  A speculator, though, isn’t worried about the fairness of the price.  They are just betting that the price will go up or betting that the price will go down.  When a market becomes dominated by speculators instead of investors, that’s when bad things start to happen.  Markets are supposed to price commodities appropriately, not act as a casino to support speculation.

We’ve seen this movie before, just a few years ago.  From February to June 2008, crude oil prices spiked 50% under a similar run-up of speculative activity.  Speculators ran up wheat prices by 80% in 2007, causing food riots in some parts of the globe.  (How do we know that speculation drove this rise?  By comparing wheat to other crops that are not widely traded, but grown in the same areas, such as potatoes.  Their prices rose significantly less over the same period of time.)

And there’s another parallel that should send a shiver down your spine.

What is happening in the crude oil market is similar to what happened in the mortgage market in 2008.

Traditional principles of mortgage underwriting were tossed to the wind as banks bundled lousy subprime mortgages into securities and sold them to other banks and investors.  When the house of cards collapsed, the financial institutions got bailed out while the rest of us got left holding the bag — and the bill.  We can’t let this happen to the crude oil market.

The good news is that there’s a simple way to limit the damage that speculators can do in the crude oil market.   We can start to regulate futures trading in crude oil the same we do with other forms of financial speculation.  The Dodd-Frank financial reform bill included provisions that allow the Commodity Futures Trading Commission (CFTC) to set reasonable limits on the numbers of futures contracts that an individual organizations or traders can hold.  This is the appropriate role of government, to make sure markets work as they are designed to work and to protect citizens from those who would game the system.

The bad news is that Republicans are the ones standing in the way of these common-sense reforms.  House Republicans have gone so far as to threaten to cut the CFTC’s funding, making implementation of such limits impossible.  So when you hear folks like Speaker of the House John Boehner blaming Barack Obama for not doing anything about high gas prices, remember who else isn’t lifting a finger to help you the next time you fill up at the pump.

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