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Why are gas prices so high? What an economist to do

19 May 2017Other Essays

Introduction

Oil prices have risen sharply over the past eight months. The rise has been so sharp that it has taken number of industry experts by surprise. For an average American on street, it has resulted into higher energy prices. The once unthinkable $4 a gallon is now sold in the streets of America and customers are cutting their essential purchases to fill the oil bill (Kenneth Musante, 2008).

Economist View of Oil Prices

Looking purely from an economic theory perspective – Prices are result of demand and supply of commodities in the market place, and according to economic theory oil is pretty inelastic product especially in developed country like United States. So the big question is what is driving the prices. This paper will look into the factors that are driving higher oil prices, particularly gasoline prices in streets of United States, how they can be countered and what economic policies the state has to initiate.

Economic factors

Price is result of demand and supply of the product. According to economic theory price can be high if the demand is more than the supply or if supply is curtailed to create an artificial shortage. In case of oil both the above are happening at this moment in the world.

Increased Demand

Over the past four years world has witnessed robust demand, never before in the history that all part of the world grow at simultaneous time period. United States, Europe, South America with Brazil, Russia, China, India and South East Asia has grown simultaneously over the past four years. This has created a strong demand for oil from all parts of the world especially from China and India which are growing at the rate of 8-10 percent annually (Ron Scherer, 2008 ). Big population and strong demand has not only increased the demand of products like cars in these countries but also requirement of oil.

Supply Bottlenecks

Oil is the precious commodity and the countries that have it try to keep a tab on supply so that they can extract higher price for it. At present three of the largest five producer of oil either don’t have overtly friendly relationship with United States, the biggest consumer of oil or having political problems (Marty Jerome, 2008). Russia the second largest producer of oil in the world has prospered vastly from high oil prices in the past few years and it has no motivation to increase supply. With the new initiated war on Georgia by Russia this supply channel is likely to be dry up further.

Similarly Venezuela doesn’t have friendly relationship with United States, even thought the state oil company of Venezuela owns almost ten thousand gas pumps in United States. Increased prices in United States mean more revenue for the state oil company of Venezuela.

Nigeria on the other hand is facing law and order problem due to mafia presence in the oil industry. Secondly the oil infrastructure is not developed in the region so supply can’t be increased to a great deal.
Infrastructure Problems and No New Discoveries

Dilapidated Infrastructure

With Hurricane Gustav hitting the Gulf of Mexico, most of the oil installations in the region are closed as a precautionary measure. The hurricane hit region still contributes around sixty percent of oil exploration of United States. Couple this with port of Louisiana where 20 percent of the oil imports of United States lands. Weather realities has not encourages investors to invest in new oil facilities in the region. In fact it has been two decades since the last major refining installation on the American soil. This has not only increased the refining cost for the fuel used in car but also increased American dependence on foreign refiners.

No New Discovery

What has worried the economists and world leader most is the fact that there are no significant oil discoveries in the past 20 years. This has become the main supporting argument of the oil depletion lobby which has prophesized that world will run out of oil in the next fifty years (Marty Jerome, 2008).

Future Trading of Oil at Commodities Exchange

What this has to do in an economic paper? Well it is one of the biggest reasons for an almost 125 percent rise in oil prices with a year. Oil is the largest traded commodity on the commodities exchange and with crash in financial market oil has become one of the favorite of speculators across the world. Amidst the fears of sub prime crisis and financial tightening number of speculators from the equity market has turned toward oil which suddenly increased not only participation but also speculation in the market. Couple the increased participation with huge share of oil futures with few players- simple artificial demand and through the roof prices. According to Washington Post swiss company Vitol along with couple of other big players once controlled around 80 percent of oil futures in June. No wonder the prices increased from $100 a barrel to $144 with in couple of weeks. (David Cho,2008)

Weakening Dollar
In the past one month the oil prices has come down from its peak of $144 a barrel to $115. Most believe that it is due to the slowing demand as economy is slowing going into recession and increased strength of dollar. For past one year dollar has decreased against all the major currencies of the world which significantly increased the price of oil because oil across the world is traded in US dollars. Weak dollar means high prices as supplier wants to have appropriate price minus the dollar weakness.
The dollar weakness is past one year is due to slowing economy and significant trade deficit.

What can Economist do?

Given the present scenario economists can’t do a great lot to bring down the prices of oil. Economists have two major tools to influence the economy – fiscal and monetary policy. Both the tools at present are stretched to the limit.

Fiscal Policy Solutions

At present economist can suggest the government to bring down excise duties on oil companies so that they can pass on the benefits to the consumers. Other than that not a lot can be done. Companies like ExxonMobile are making unprecedented profits due to the increased price but they can’t be taxed differently from other industries or companies. One step in future could be providing tax incentives to new technologies that can replace oil. But it is for the future and can’t help to ease the present oil price crisis.

Monetary Policy

Monetary policy has been stretched to the limits with the financial crisis and economic slowdown. Irresponsible lending has resulted into sub prime crisis which has shaken even the best of the players including Federal Reserve which is still not sure how much the companies will write down. To ease the credit tightening the Fed has continuously brought down lending rates and discount rates but now they have reached a place where they can’t go further.

High oil prices have fueled not only fears of inflation but inflation itself. The commodities prices including steel, zinc, copper etc are at their all time high and can only come down once the demand will taper off. Crash in housing industry has also left thousands of household bankrupt in United States so no new demand generation. Even the stimulus package has fallen on its back.

Conclusion

High oil prices are due to high demand and speculation, once the demand of the oil taper down due to slowing economies across the world the oil prices will also come down. On a personal front people can take options like buying hybrid cars but on a broader level government can only hope for slowing growth.

References

  • David Cho (August 2008) A Few Speculators Dominate Vast Market for Oil Trading.
  • Marty Jerome (May, 2008) Get Used to It -- Sky-High Oil Prices Are Here to Stay. Retrieved on 1st September 2008 from https://www.wired.com/2008/05/are-oil-prices
  • Opec (2008). How long does it take to discover oil and bring it to market?
  • Ron Scherer (April, 2008 )The rising impact of high oil prices. 
  • Rose Ragsdale (January, 2008 )High oil prices? You ain’t seen nothing yet. 
  • Kenneth Musante (August 2008)Gas price decline nears 40 cents.

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