Tuesday, July 1, 2008

Gas prices explained

This article is in response to the "Let's All Boycott Exxon and Mobil Gas Station's" email which I receive fairly regularly.I love when I get this email, because I get to again remind myself and others of how gas prices are set.Let me clarify with this article, which I'll call "Peak Oil: The Story Behind Gas Prices".

#1 Not buying gas from an Exxon or Mobil station doesn't impact Exxon Corporation or Mobil Corporation, since they sell their gasoline to whichever distributor need it, no matter if it ends up at a BP or a Crystal Flash or Bob's Cheap Gas. The only person that boycotting a station hurts is the owner or franchisee of that particular station, their family, and probably their employees. They feed their family because of the Coke's and snacks we buy in their stores. They are lucky to make a dime on each gallon they sell.

#2 Long term gasoline prices are NOT set by oil companies. They are set at auction by bidding on the New York Mercantile Exchange. Gasoline is purchased months in advance using "futures contracts", which can be bought for next month, two months from now, or even years from now. The "futures contracts" for the current month, as it gets close to completion, are traded, just like stocks on the stock market. The contracts go up and down in price based on the demand for them. The final price for that "futures contract" determines the "spot price", which is the price that very moment, which in turn determines the price the distributor sets. The service station gets the word once a day from the distributor, usually around 4 p.m. afternoon, as to the price at which they should retail.

#3 At auction, the price has been bid up over the past five years because of increasing demand. There are more uses for oil products all around the world, and more users everyday. More cars in the US, China, Russia, India, etc. More products being made and shipped to us. The more demand, the higher the price.

#4 The reason gasoline prices weren't rising through the 80's and 90's was because oil supply or oil production increased at about the same annual rate as demand (about 1.5% per year).

#5 Oil production stopped increasing in 2004. Global daily production is has been basically fixed at 84.5 million barrels per day since then. While demand is rising, and yet supply is not, price will go up, because this is a bidding auction or a free market.

#6 If oil production continues at this 84.5 mbpd level, expect gas prices to double every four years. That means that gasoline would be 10 USD per gallon within 7 years. Oil prices would be to 1,000 USD per barrel within 10 years.

#7 If we have a worldwide recession, which decreases worldwide demand for oil AND oil producting nations/countries are able to, and also decide to, maintain the 84.5 million barrel per day production level, THEN we MIGHT see gasoline and oil prices decline.

#8 Worldwide oil production is probably fixed at 84.5 mbpd because we are at the MAXIMUM global oil extraction rate. This is known as global peak oil production or simply "peak oil".

#9 Once it becomes impossible to continue extraction at the incredibly high rate of 84.5 mbpd, oil production will fall, every year, forever. This means rapidly rising prices (much more so than now) and/or severe global economic recession, or more likely, a string of ever worsening recessions, that continue for a few generations.

#10 It is unclear how much longer the oil producers can maintain 84.5 mbpd. I hope it is for a long time, but production may begin to fall as early as this year. The rate that production falls will determine how fast prices rise, and how severe the shock is to the global economy.In summary, gasoline prices are determined by the free market of supply and demand. They are rising because of a fixed oil supply in a market of increasing demand for oil. Supply may be at the all time maximum, and may begin to decrease, which will in turn, accelerate the increase in the price. This is bad news for the global economy because, like fresh water, oil is a "master resource", upon which all economic activity depends......

Note: The 84.5 million barrels per day figure is based on averaging out 12-months of oil production data from the USA's Department of Energy's "Energy Information Agency" (EIA). I've seen other daily production numbers tossed around online and in the press, but I think the EIA data is fairly reliable, and the trends shown there are probably the same for any other dataset. In any event, the exact numbers are not of great practical importance, instead, of interest are the rate of change of these numbers.

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