Thursday, March 17, 2011

So, why is gas REALLY so expensive?

According to most of the leading economists and analysts who specialize in this kind of stuff, gas prices are on track to break the record high set in 2008 by this summer.  That would put the average price of gas at over $4.60 a gallon nationwide, which, for people like myself who are lucky enough to live in the Golden State, means prices will break the $5 mark, and probably then some.  There are a lot of conflicting answers floating around as to why this is.  Some say that it's the high price of oil, yet oil prices keep dropping while gas prices continue to rise.  Others say it's the conflict in the middle east, even though the U.S. imports most of it's oil from Canda, and only a fraction of our oil comes from Libya or any region in the middle east currently affected by political instability.  Still others say it's a reaction to increased worldwide demand that is cutting into the supply of oil produced, but the heads of OPEC have stated again and again that the increase in gas prices has nothing at all to do with the supply of oil, that they are supplying more than enough oil to keep prices stable and reasonable.  So, what's the truth?  What are the real reasons why gas prices continue to rise even as oil prices are falling?  Let's cut through the smoke and mirrors and get to the heart of the issue.  First, a quick Econ refresher.

Supply and Demand

The biggest reason that the petroleum industry always gives for why gas prices continue to rise is simple supply and demand.  It makes sense that they say this, it's the most basic mechanic in the free market, and a concept that anyone who's passed the 10th grade is familiar with.  I mean, even the guy who sells you weed knows that if everyone in town has bud, he's gotta lower his prices, but if times are dry and he's the only guy with the fat sack, then he can pretty much charge whatever he wants.  So, it's logical and it's easy to sell to people who like short, simple and easy to remember answers to why they're getting anally raped every time they fill up.  However, supply and demand have almost nothing to do with the increasing gas prices.

See, as I mentioned before, OPEC has stated on numerous occasions that there is more than enough oil being produced every day to keep up with demand.  In fact, the excess of supply in the market right now is why oil prices are actually dropping.  Based on supply and demand, gas prices should be going down right now, not up.
Oil Price Per Barrel, Feb. 2011    Oil Price Per Barrel, Mar. 2011
$105                                                $98

Gas Price Per Gallon, Feb 2011    Gas Price Per Gallon, Mar. 2011
$3.33                                                $3.61

You see, gas prices are reacting in direct opposition to the law of supply and demand.  Lower oil prices should mean lower gas prices, yet even as oil prices tumble in the wake of the earthquake in Japan which resulted in the closure of several oil refineries and a sharp decline in oil demand on the open market, gas prices continue to rise, and at a rate that far exceeds inflation or any other generally attributed market fluctuation factor.  You're looking at about a 10% increase in gas price per month and a 7-8% decrease in oil prices over the same period.  Any way you slice it, that's about 17-18% more revenue being generated after the oil is bought off the open market.

So, if oil prices (and thus, those "damned Arabs") aren't responsible for higher gas prices, who is?

The Commodities Market (A not-so-brief primer)

The commodities market, and in particular, the "futures contracts" market are not new concepts.  Any farmer, dairyman or rancher should be familiar with futures contracts, as they became an integral part of the agriculture industry almost as soon as they were introduced.  Essentially, the commodities market is a branch of the stock market where producers are put in touch with buyers for their produce - called "brokers", and the two parties agree on conditions such as product, grade, quantity and location and the only negotiations are over selling price.
For example - a corn farmer who might otherwise have a difficult time selling his entire harvest at market can put his produce up for sale on the commodities market.  A corn broker will see that this farmer has so many bushels of corn that's high-grade, good quality and ready for delivery from his silos.  The broker would then negotiate a purchase price for the corn with the farmer, buy the corn, take delivery of that corn and would attempt to profit from his investment by selling the corn to other buyers for an increased price.

Eventually, farmers and brokers started creating contracts with each other, where the farmers would agree to deliver a specific amount of produce on a certain date in the future, and the broker would agree to pay a specific price for that delivery on that date.  This is what's known as a "futures contract".  This allowed not just a better means for farmers to get their produce to market more easily, but it also created a new investment vehicle, as the broker could now sell those futures contracts to investors who would purchase the contracts based on their predictions for crop performance that year.   
For example - a corn farmer agrees to sell 100 bushells of corn for $5 a bushell, with delivery to take place after the harvest.  The broker buys that contract with the intent of taking delivery on the specified date and paying the agreed upon amount at that time.  After buying the contract from the farmer, the broker is contacted by an investor who believes corn prices are going to increase sharply for whatever reason, and he offers to buy the broker's contract for $7 a bushell.  The broker can now sell the contract to the investor, profit $2 per bushell, and all he has to do is pay the farmer on the delivery date.  The investor now owns the corn and can either hold onto it and sell it at a profit if his prediction was correct, or he can in turn sell the contract to another investor at an even higher price.
The upside to futures trading is that, if competitive supply is low and demand is high, huge profits can be made.  The downside is that if the farmer has a bad harvest and can't meet the contracted amount, or if there is a surplus harvest and the market is flooded with produce, everyone involved can suffer huge losses.

The key to the commodities exchange as it stood for decades was "Taking delivery upon purchase".  Even when the commodities market expanded to include fuel, textiles and currency, the holder of the contract always had to take delivery upon purchase.  In other words, you couldn't buy all that farmer's corn and leave it sitting in the farmer's silo's until you found a buyer, you had to take possession of it and store it yourself until you sold or used it.  This regulated the commodities market by limiting activity to people with business wholly or partly related to the industry.  Even people who were only buying commodities futures as investors had to have the means to take delivery of their contracts when they were ready.  This prevented people from sitting in an office, buying and selling futures contracts and using speculation to drive up the price of staple products such as food, fuel and textiles.

Gradually, the infrastructure and guidelines for food and precious metals commodities trading would be built upon to allow the futures market to expand and include oil and other fuels as well as financial markets, stocks and bonds.

This became a problem in the early 1970's when brokers began to sell single stock futures and began a practice known as "pump and dump", where a group of brokers would purchase stock in a company "on a margin" - meaning they agreed to take possession of a stock at current market value, hold it for a specific amount of time, then buy the stock at the original price, regardless of what the current market value was - they would then "pump" up it's value by hyping up the market, floating rumors, aggressively marketing or any other means they could, then "dump" the stock off on investors who took the bait and bought it at a greatly inflated price.  This practice allowed savvy investors to make a fortune with little or no investment capital at all.  They could basically buy stock on credit using the margin system, sell it for a higher price, pay off the original contracted amount and keep the profit.  However, this practice was also extremely detrimental to the companies who's stock was being manipulated this way, as huge stock price fluxuations scared away serious investors and ultimately damaged the companies inherent value.  When investors began to do this with the commodities market, congress saw the potential for reckless speculatory inflation in essential markets, such a fuel and food, and they passed legislation to ban the practice in the early 1980's.

 However, in late 2000, a bill was introduced to lift the ban on single-stock futures trading.  The Commodities Futures Modernization Act was passed on Dec. 21st, 2000.  The passage of this act removed many of the long-standing regulations on the commodities futues market and allowed for more flexibility in how trades could be conducted.  Most notably, it allowed futures contracts to be traded without the buyer having to take possession of the commodities upon receipt of the contract.  What this meant was that now anyone with a laptop and an E-Trade account could buy and sell corn, rice, soybeans, jet fuel, light sweet crude oil, gold or cotton futures - to name just a fraction - and sell them without having to ever take possession of a single barrel, bushell, drum or bar.  Most notably, however, was that this new act allowed for two particular types of trading that would become a big part of the historic boom and bust of the market that culminated in the 2008 financial crisis, global market collapse and resulting recession.  One, was the prohibition of the SEC from regulating new financial investment products, namely credit default swaps.  The other was the creation of what's now known as the "Enron loophole", a provision that allowed energy trading in unregulated markets.

Thank you for reading all that, now here's what it all has to do with gas prices!

We all know what the creation of unregulated credit default swaps did to the housing market.  The 300% drop in home prices from 2008-2010 and the 10-30% foreclosure rate, depending on location, across the country stands as a sad and painful testament to the damage caused by unrestricted speculation and the mutation of the stock market from a medium for investment to the world's largest casino.  In the span of 10 years, investing became gambling, and the gamblers were playing with the house's money.  Businesses went bankrupt, pensions were lost, entire hedge funds were wiped out and hundreds of thousands of hard-working Americans found themselves approaching the home stretch to retirement only to learn that their 401k's were gone, their company was about to lay them off and the bank was going to take their home.  Well, the same thing that happened to the housing market was happening to the fuel market...

In an attempt to offset the huge losses they were taking on the collapse of the credit default swap market, hedge fund managers, investment houses and brokers began buying heavily into the oil and food futures markets and using speculation to drive up prices in both industries.  Speculation and investment hype, driven primarily by the world's largest investment firms and every major media outlet created artificial shortages which led to exaggerated demand and spiked food and fuel prices.  A completely media-manufactured story about the possibility of a rice shortage in Asia drove up rice prices almost 400% in the span of a month and led to an actual shortage as people panicked and began stocking up on rice in preparation for this imaginary shortage, and ended up creating a real shortage as a result.  A similar artificial shortage was created in the corn market, largely due to the passing of a puzzling bill to research corn-based fuel that apparently didn't have much of a purpose other than to take a huge chunk of corn off the market and do almost nothing with it, since there wasn't really a solid framework in place to actually develop the fuel.  Basically, under the guise of "Corn-based fuel research" enough corn to create a shortage was taken off the market, no corn-based fuel was ever created, food prices rose about 25% across the board and corn futures investors made a ton of money.

The same exact thing happened with gas prices.  Speculators first drove up the price of oil to over $100 a barrel, then they drove up gas prices to almost $5 a gallon.  The fact that they did all this through futures trading meant that, even when oil prices dropped drastically, gas prices stayed high.  This allowed both investors and gas companies to make huge profits, and in the case of the gas companies, they profitted more than any other corporation in the history of the stock market, ever.  After both the food and fuel speculation died down and wholesale prices dropped back to pre-2008 levels, retail prices in both industries stayed the same.  Why is this?  Again, going back to supply and demand, if wholesale prices drop, then retail prices should follow suit, as competition in the market and reduced demand from consumers would dictate, right?  Well, back when there was enough competition in the market to facilitate such price elasticity, this would indeed be the case.  However, in the post-deregulatory era, laxed restrictions on corporate mergers have led to the creation of the "MegaCorps" in every major industry from food and fuel production, to multimedia companies to insurance companies to banks and investment houses.  Today nearly every major industry in America is controlled primarily by about 5-8 Mega Corporations.  When you only have about 5 gas companies controlling nearly 90% of the petroleum market, there's not going to be a lot of price competition.  When you have 6 major corporations producing 90% of the food products in your local supermarket, there's not going to be a lot of price competition.  And so on, and so on...

So, in a nutshell, the reason why gas (and food, and insurance, and etc. etc) prices are so high today?  Because they can.  There's almost no competition in any major industry anymore.  Collusion and corruption is rampant.  If Exxon/Mobil wants to keep gas prices at $4 a gallon, even when oil prices dictate it shouldn't be any higher than $2.50 a gallon, who's going to undercut them?  BP?  Arco?  Texaco?  Shell?  Why should they, when they can keep their gas prices just as high and make just as much profit?  If corn prices have dropped back down to a reasonable level that food prices should be back to where they were before 2008, and Tyson wants to keep selling it's corn-fed chicken at the current inflated price, who's going to stop them?  One of the 4 other companies who, along with Tyson, control 85% of the chicken production in America?  Or are they all going to keep their prices high and continue to make record profits?

Remember what I said about the weed dealer at the beginning of this whole verbose diatribe?  If 5 guys in town are responsible for 90% of the weed sales and they all realize that as long as they all keep selling their weed for the same price, people will keep buying it, no matter how much cheaper they get it for, what possible incentive would they have for lowering their prices?  Suppose one guy decides to undercut them all by $20 a bag, all they have to do is spread rumors about dude's weed being shitty, or maybe plant a story about him being a narc, and he's pushed right out of the market.  The same exact thing is happening in the corporate world every day.  New businesses emerge to offer competitive pricing and they are promptly smacked down by the combined might of the MegaCorp collectives.  Whenever a new bank opens that offers competitive rates, they are either bankrupted or acquired by one of the "Big 6" banks soon afterwards.  Whenever a new food producer enters the market, same thing.  Whenever a company offers promising research into alternative fuels, suddenly we see the passing of new legislation that conveniently drives up the cost of that fuel, regulates the company into bankruptcy, or a major petroleum company simply buys them out and sticks them in a back room to rot.  This is what happened to the electric car.  The first production-ready electric car of the modern era was unveiled in the 1970's.  It was bought by GM and never seen again until the Saturn EV-1 was built and test-marketed across the country in the 1990's.  The EV-1 was a huge hit with the test-marketers, who raved about its performance, ease of use, convenience and reliability.  However, in spite of what was an overwhelming approval of the EV-1 by it's test-owners, GM bought back all the cars on the road and completely killed the project.  To this day, GM's latest incarnation of the electric car - the Volt - is little more than an autoshow gimmick that gets trotted out every year with the promise of impending production that never materializes.

Even now, with gas companies continuing to shatter profit records with each successive quarter, and currently setting yet another all-time record for profits as I type this, they have already begun preparing the American people for the inevitable summer price hikes.  For what reason?  Well, because gas prices ALWAYS go up during the summer, duh!  Not because there's any shortage of supply, not because production prices have increased, not because demand is any higher this year than it is in any other year, not that they haven't completely and thouroughly accounted for any potential demand spikes anyway (they have teams of very smart, very well-paid accountants to make sure of that), but simply because it's a tradition that gas prices always go up during the summer.  Because they know that the average American is not going to stop driving and start walking or riding a bike, and yes they have already taken into account the projected number of people who WILL do that, and adjusted gas prices accordingly to compensate.  It's not because of conflict in the Arab world, it's not because of earthquakes and tsunamis, it's not because of those damned environmentalists and their regulations, it's not because of our socialist administration and their oppresive fuel taxes and it's not because we refuse to "Drill, Baby, Drill!"  It's all because of gas companies and stock market gamblers, just doing what anyone would do if they sat down at a broken slot machine that paid out on every pull - getting all the money they can before someone catches on and shuts it down.  Unfortunately, they're splitting their cut with the house so they'll keep looking the other way.

Oh but hey, enjoy your Memorial Day weekend!


  1. OMG, I read through the whole thing! So in the end, it's all really our fault. As long as we buy gas at the prices it's at, the prices will stay there. The solution is to use less. I refuse to buy a second car for commuting. I'll take the bus, thanks. I get a nice 45-minute nap every morning. :)

    - Matt (Qisa)

  2. Basically, I guess yeah. :) Gas companies will charge as much as the people can stand to pay and they won't stop as long as people keep buying. If demand for gas dropped to the point that it was more profitable to lower prices, then they would, but they won't until that point. However gas prices got to where they are, all it takes is for Americans to buy less and the gas companies would have no choice but to lower prices. It's all about the bottom line, and that's where the supply/demand curve still works in the consumer's favor.

    The problem is, gas companies have spent a ton of money to convince us that the answer isn't really that simple and that price increases are out of their hands, so that we'll just grit our teeth and take it, and it's been working great for the last 11 years...