Hot Topic: What's Up With Gas Prices?
Student Reading
On April 14th 2008, the national average price for a gallon of regular
gasoline reached a new all-time, inflation-adjusted high of $3.37. But
people are driving less and oil supplies are increasing! Decreasing
demand
and increasing supply should lower the price of gasoline; so why are gas
prices rising? Is it the election? A conspiracy? Price gouging oil
companies? Or might supply and demand still have something to do with
this
mystery?
Before the new records set in March and April of 2008, the highest
historical price for gasoline was in May, 1981 when the average price was
$1.36/gallon. In today’s dollars, that’s the equivalent of $3.22. While
gasoline and oil prices have reached and passed the highs of the ‘80s,
they’re
high for different reasons. Read the excerpts from two articles below for
a
comparison between the factors influencing gas prices then and gas prices
now.
Gas prices strike all-time high (CNNMoney.com, March 31, 2008)
Average gasoline prices have hit another all-time high, according to a
survey conducted for motorist organization AAA.
The average price of regular rose to $3.287 a gallon, up from $3.286 the
previous day, according to the AAA Web site.
The price averaged $3.165 a month ago. A year ago, American drivers were
paying $2.673, according to AAA.
.. . . Analysts say surging crude prices are largely to blame for pricey
gas.
Crude topped $100 a barrel in early 2008, and has traded above $100 for
most
of the year.
While gasoline prices have hit record highs well before the start of the
summer driving season, most analysts expect prices to peak relatively
early - somewhere between $3.30 and $3.80 a gallon - and then decline
during
the second half of the spring as a slowing economy crimps demand. SOURCE
LINK
Oil Prices Pass Record Set in ’80s, but Then Recede
(by Jad Mouawad, NY Times, March 3, 2008)
Since 2000, oil prices have more than quadrupled as strong growth in
demand
from the United States and Asia outstripped the ability of oil producers
to
increase their output.
The rising prices of the past decade failed to dent global economic growth
as consumers absorbed the higher costs. Even now, with the United States
economy slowing markedly, the trend has not slowed much. Global oil
consumption is still expected to increase by 1.4 million barrels a day
this
year, driven by demand in China and the Middle East.
Still, today’s record is markedly different from the energy crises of the
1970s and 1980s. These were brought about by sudden interruptions in oil
supplies, such as the 1973 Arab oil embargo, the Iranian revolution of
1979,
or the outbreak of the war between Iran and Iraq in 1980.
Also, the United States economy at the time was much more dependent on oil
than it is today. The amount of oil needed to increase economic output by
$1
has dropped by 25 percent since 1990.
In the early 1980s, energy accounted for about 8 percent of disposable
income in American households. As the economy became less energy-intensive
and prices declined, that share fell under 4 percent in the early 1990s.
But as prices keep rising, the share of energy spending has been
increasing.
It reached more than 6 percent of household disposable income in December.
SOURCE LINK
Since the year 2000, increasing demand for gasoline, mainly from Asia and
the United States, has lead to rising gas prices. An increase in demand
(shift of the demand curve to the right) means that consumers are willing
and able to buy more gas at any given price. However, according to the
Dept. of Economic Analysis, demand for gasoline has actually decreased by
1%
since January. When demand decreases, or (shifts to the left – see graph
below), the equilibrium price and quantity decrease. Why then, are prices
still rising?
Economists and analysts think that commodities markets, gasoline futures
contracts, and the exchange rate may have something to do with the rising
prices. Because of news reports on “the Dow’, most of us are aware that
investors buy and sell stocks in markets like the New York Stock Exchange
or
the NASDAQ, but we may not realize that investors also buy and sell
futures
contracts for commodities such as iron ore, gold, sugar, crude oil, and
gasoline. Every day billions of dollars in commodities are bought and
sold
on the floors of commodities exchanges like the Chicago Board of Trade
(CBOT) or the New York Mercantile Exchange (NYMEX). As buyers and sellers
interact, commodities prices change, and those changes can affect the
price
we pay for gasoline at the pump.
A futures contract is an agreement to buy or sell a commodity at a
prearranged future date and price. The basic purpose of a futures
contract
is to provide price-change protection. For example, a farmer estimates
that
it will cost $2 a bushel to produce his wheat. Rather than run the risk
that the market price for wheat will be less than $2 at harvest time, he
can
enter into a contract now to deliver the wheat at harvest time for a price
of $2.50. At the same time, a food processing company may want to enter
into a contract now to receive the wheat for $2.50 rather than run the
risk
that the market price at harvest time may be higher than $2.50.
However, the buyers and sellers of the actual commodities are not the only
players in the futures market. Speculators buy and sell futures contracts,
but have no desire to own the actual commodity; they see the possibility
of
price change as an opportunity for profit. A speculator who anticipates a
commodity price increase will buy a futures contract now with the hope of
selling it at a higher price later on. On the other hand, a speculator
who
anticipates that a commodity price will decrease, will sell a contract he
doesn’t own (a practice called selling short) with the hopes of being able
to buy it back at a lower price.
Contracts are bought and sold many times over before the contract date
when
the actual commodity must be delivered. In fact, the Chicago Board of
Trade
estimates that only four percent or less of what is traded, actually gets
delivered as businesses attempt to manage risk and speculators attempt to
profit by anticipating price changes.
A final piece of the puzzle of rising gas prices in a time of falling
demand
is the exchange rate. In order to trade goods and services with other
countries, businesses must first exchange currencies. Currencies are
bought
and sold in the foreign exchange market and the term exchange rate refers
to
the price of one currency in another – or how much of one currency it
takes
to buy another currency. If it takes more and more dollars to buy one
euro,
then we would say that the dollar is depreciating relative to the euro and
the euro is appreciating relative to the dollar. The articles below refer
to a “falling dollar” which, in general, means the dollar is depreciating
relative to other currencies. Sometimes this is also referred to as a
“weak
dollar.” That means foreign investors can buy more dollars for less of
their own currency. And then, rather than just holding those American
dollars and watching them lose value as the dollar falls or inflation
decreases the purchasing power of the dollar, they can invest in things
for
which they expect the price to rise faster than inflation… like gasoline
or
crude oil futures contracts.
Read the following excerpts and pay close attention to the role that
commodities markets, futures contracts, and exchange rates are playing in
the rising gas price saga.
Gas Prices Near Records, Following Oil (by John Wilen, Associated Press,
March 10, 2008)
.. . . Many analysts believe speculative investing attracted by the weak
dollar is the primary reason oil has risen so far so fast in recent
months.
Crude futures offer a hedge against a falling dollar, and oil futures
bought
and sold in dollars are more attractive to foreign investors when the
dollar
is falling.
.. . . Many investors believe the greenback is likely to keep falling as
the
Fed continues to cut [interest] rates. Many analysts believe the rise in
crude prices is not supported by the market's underlying fundamentals,
noting that supplies are generally rising while demand is falling.
"By gobbling up everything in sight, [investors] are pushing food and fuel
prices to ruinously high levels," said Peter Beutel, president of the
energy
risk management firm Cameron Hanover, in a research note. SOURCE LINK
Good Question: If people are driving less, why do gas prices keep rising?
(by John Wilen, Associated Press, March 21, 2008)
Q: If people are driving less, why do gas prices keep rising?
A: People are indeed driving less. Gas consumption has fallen about 1
percent since late January.
Yet, gas prices are on the rise. Gas has averaged more than $3 a gallon
for
four straight months and, more recently, has surged into record territory.
Estimates of how high gas prices will go this year vary from $3.50 a
gallon
to $4. But virtually everyone agrees prices have higher to go before they
fall.
This disconnect between demand and price may seem to violate fundamental
rules of economics, but gas prices are actually responding to demand of a
different kind: from investors.
Contrary to the views of many conspiracy theorists, gas prices aren't set
by
refiners or gas stations as part of a campaign to gouge consumers. Prices
are a function of the open market, as manifested in the trading of futures
contracts on the New York Mercantile Exchange, or Nymex.
Nymex gasoline futures have been rising, following oil, despite growing
supplies of both commodities. Blame the falling dollar, which has made
dollar-denominated oil contracts irresistible to foreign investors and to
any investors looking for a safe haven for their money during a turbulent
time in the stock market.
This buying by investors has pushed oil futures to a series of records in
recent weeks, and the rest of the energy complex -- which includes
gasoline
futures -- has followed.
Unfortunately, consumers pay for this investment frenzy in the form of
higher pump prices. And despite mounting evidence that Americans are
cutting
back on their gasoline habit -- and may cut back even more drastically as
gas gets more expensive -- it might be some time before prices start
responding to lower demand. SOURCE LINK
Questions for Discussion:
a.. What caused the high oil prices of the early 1980s?
a.. What explains the general rise in oil prices from 2000 to 2008?
a.. Despite the decrease in demand and the increase in supply, what
explains the recent and continued rise in gasoline prices since January,
2008?
a.. If the Federal Reserve continues to enact expansionary monetary
policy
(i.e. “the Fed continues to cut rates”), what impact do you think this
will
have on the value of the dollar relative to foreign currencies? How would
that impact futures contracts for crude oil and gasoline? And how would
this impact gasoline prices?
a.. Markets are dynamic. There is constant pressure on supply and
demand
from all directions. Identify some variables referred to in these
articles
that could increase the demand for gasoline. Decrease? (Optional: Use a
graph to illustrate each of these changes in demand on the equilibrium
price
and quantity of gasoline.)
a.. What are some variables referred to in these articles that could
increase the supply of gasoline? Decrease? (Optional: Use a graph to
illustrate each of these changes in supply on the equilibrium price and
quantity of gasoline.)
a.. If the supply of gasoline increases at the same time demand
increases,
what can you say for sure about equilibrium price and/or quantity.
(Optional: Use a graph to illustrate your answer
Teacher Guide to Discussion Questions
1) What caused the high oil prices of the early 1980s?
The “energy crises of the 1970s and 1980s . . . was brought about by
sudden interruptions in oil supplies, such as the 1973 Arab oil embargo,
the
Iranian revolution of 1979, [and] the outbreak of the war between Iran and
Iraq in 1980.”
2) What explains the rising oil prices from 2000 to 2006?
A rising demand world-wide for oil. “Global oil consumption is still
expected to increase by 1.4 million barrels a day this year, driven by
demand in China and the Middle East.”
3) Despite the 1% decrease in demand since January, 2008 and the increased
supplies of oil, what explains the recent and continued rise in gasoline
prices today?
“Blame the falling dollar, which has made dollar-denominated oil
contracts
irresistible to foreign investors and to any investors looking for a safe
haven for their money during a turbulent time in the stock market.”
“Investors desperate for havens in a deep housing market slump are
buying
up all kinds of commodities, including oil. In addition, a weak dollar
makes
oil cheaper in foreign nations.”
4) If the Federal Reserve continues to enact expansionary monetary policy
(i.e. “the Fed continues to cut rates”), what impact will this have on the
value of the dollar relative to foreign currencies? How will that impact
futures contracts for crude oil and gasoline? And how would this impact
gasoline prices?
Expansionary monetary policy may lead to higher price levels (inflation)
for everything we buy with dollars . . . including other currencies. In
other words, it will take more dollars to buy those foreign currencies.
The
dollar will depreciate relative to foreign currencies. That could
continue
to spur demand by foreign investors for oil and gas futures (which are
traded in dollars), and that increase in demand for futures could
ultimately
lead to even higher prices for gasoline.
5) Markets are dynamic. There is constant pressure on supply and demand
from all directions. Identify some variables referred to in these
articles
that could increase the demand for gasoline? Decrease? (Optional: Use a
graph to illustrate each of these changes in demand on the equilibrium
price
and quantity of gasoline.)
Increase
-Summer driving season
-Increase in oil consumption in China and Middle East
Decrease
Slower economy
“Americans… cutting back on their gasoline habit”
6) Identify some variables referred to in these articles that could
increase
the supply of gasoline? Decrease? (Optional: Use a graph to illustrate
each of these changes in supply on the equilibrium price and quantity of
gasoline.)
Increase
“…ability of oil producers to increase their output” (i.e. improved
technology, discovery of new resources)
Decrease
-increase in price of crude (an input for gas)
-hurricane, war, or other supply disruption
7) If the supply of gasoline increases at the same time demand increases,
can you say for sure what will happen to the equilibrium price and
quantity?
(Optional: Use a graph to illustrate your answer.)
When supply and demand increase at the same time, more will be exchanged
(equilibrium quantity will increase). Equilibrium price, however, may
increase, decrease, or stay the same, depending on the relative size of
each
shift. For example, if the increase in demand is greater than the
increase
in supply, price will rise. If the increase in supply is greater than the
increase in demand, price will fall.
Optional Extension Activities
a.. Provide students more experience with real and nominal values. In
general, prices are higher today than in years past because of inflation,
but when we adjust for inflation, the real prices for many goods today are
actually lower than in years past. Real prices are adjusted for
inflation.
Nominal prices are not; they are the prices that appear on price tags.
Nominal gas prices are at an all-time high, but until recently, today’s
prices were lower than those of the 1980s when they were adjusted for
inflation. Search the web to find prices of other goods in the 1980s.
Then
find an inflation calculator on the internet and calculate the “real
price” - what those goods would cost in today’s dollars. Are real prices
for those goods higher or lower than today?
Inflation Calculators:
http://data.bls.gov/cgi-bin/cpicalc.pl
http://woodrow.mpls.frb.fed.us/Research/data/us/calc/
In The 80’s: http://www.inthe80s.com
a.. Have students visit the NYMEX.com website and read about “How the
Exchange Works.” Divide the class into 2 or 3 large groups and have each
group create a short skit to illustrate how commodities exchanges work.
b.. Have students visit NYMEX.com to check on the current prices for
gasoline and crude oil futures. Ask them to describe the overall trend in
the price of the futures contracts over the past month. Then ask them to
predict what they think will happen to the prices over the next month.
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R J Talley
Teacher/James Madison Fellow
"What? Me Worry? Alfred E Newman
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