While visiting relatives last week I saw some television. Since we don’t have a TV hooked up to watch any type of broadcast programming, it was interesting to see some of the things that are on now days. On one show (I think it was the O’Reilly Factor) the host was interviewing someone who had written a book about oil, oil prices or something like that. The host kept asking the guy “so who sets the price of oil.” The author tried to explain that it was a market, but the O’Reilly didn’t seem to get it and asked, “so does OPEC set the price of oil?”
Then I saw on the news that several presidential candidates are contemplating a gas tax holiday during the summer months. This leads me to believe that they don’t have the slightest how the price of oil is set either. While I’m not an expert by any means, I’ve come to the conclusion that I know more about how the price of oil is set than 66% of the leading presidential candidates and at least one television host, so I’m going to go ahead and explain it here along with some thoughts on how to lower gas prices. Feel free to correct me if I get something, wrong or you disagree with anything I say.
There isn’t a person out there who is “setting” the price of oil. Oil is sold on a market. That means if demand goes down, so does the price. When demand goes up, the price goes up until it gets to the point where the supply meets the demand. This is the same way that stocks work. If thousands of people own stock in a company there are almost always people who want to buy and people who want to sell. Joe owns stock and wants to pull it out to buy a house. Sue just got an inheritance and wants to put it into the stock, etc.
Stocks
If I want to buy a stock, but I’m only willing to pay $10 and Joe wants to sell his stock for $12 it would appear that we are at a standoff. But in a large market this virtually never happens. There is usually someone willing to sell for the price someone else is willing to buy. It is extremely unlikely that hundreds of thousands of people who own a stock are going to somehow think it is worth significantly more than everyone else who doesn’t own the stock. The price that the stock trades at is consider its price–it is the value that people have agreed the stock is worth. It isn’t determined by anyone–it is determined by everyone. Oil prices work the same way.
OPEC
OPEC is an acronym for the highly creative name of Organization of Petroleum Exporting Countries. It was founded in 1960 and basically is a bunch of countries who get together and collectively decide how much oil they are going to sell on the market. They can’t directly control the price, but they realize that if everyone floods the market with oil the price will go down. In fact this happened in 1986 because of a great decrease in demand for oil.
Now OPEC has an extremely delicate balance. If prices are high, countries don’t mind scaling back their production to keep them high. However, if the prices go lower countries that need money may be tempted to sell more oil to try to make more money on volume. If they break from the production quota they have been assigned, it will eventually force the prices lower because it will reduce demand. It will also tend to undermine OPEC because other countries will want to up their production to make up for the lower prices.
Currently the members of OPEC are putting out about 30,000,000 barrels of oil each day–about 2,000,000 lower than the world capacity of OPEC countries. No country has a huge incentive to up production because they are so close to maximum production already–and since prices are high they aren’t hurting for money.
Gas Tax Holiday
Right now the federal US government imposes a tax of 18 cents per gallon on gasoline. The tax holiday proposes to eliminate that tax during the summer months. This is an absolutely horrible idea. It would only temporarily lower the price. I know people who have stopped traveling in their RV because of the expense. If the 18 cents was enough to convince them (and others like them) to head back out to the road, it is going to increase demand. In fact anything done to temporarily lower the price of gas is going to increase demand. So lets say we lower the price by 18 cents for 3 months. When fall comes around and the tax goes back into effect, the price of gas will have risen to take into account the increase in demand. So in the end, everyone is worse of instead of better.
I’m all for the government lowering taxes, but this suggestion is very scary–especially coming from people who want to lead the country. It reveals a fundamental lack of economic understanding. It is the type of thing that a politician will do to try to look good in the short run, but is harmful in the long term. It is easy to come up with ideas to make yourself look good when you ignore the consequences 6 months down the road. (For the record I think the rebate check was a bad idea too.)
Lower Gas Prices
So how do we lower gas prices? Simple, we have to lower demand. OPEC is not going to be able to keep countries within their quota if everyone is being asked to operate at 30% of their production capacity.
The cool thing, is that everyone can do something to lower demand–and it isn’t even that hard. There are somewhere around 135 to 145 millioin working adults in the US. We will limit our calculations to just include them. Imagine that everyone figures out a way to reduce the amount of gas they spend by 1 gallon each week. This translates into driving 20 to 25 miles less each week. According to my calculations this would save around 1 million barrels of oil each day which would reduce global demand by about 3%.
140,000,000 * 52 (weeks in year)/ 365 (days in year) /19.5 (gallons per barrel of oil) = 1,022,831 (gallons of gas saved)
Yes I know these are all approximations. Yes I know that not everyone has a car. But keep in mind that we are just looking at the working population. There are many other people who we haven’t even included.
So how do you save one gallon of gas each week? You act in your own self interest to save money by driving less. For most vehicles this works out to driving about 20 to 25 miles less per week. Most people would save this amount of gas if they just planned out their travel a bit more carefully. Instead of going to the store twice each week, plan ahead and go once. Better yet go once every two weeks. Here are a list of very simple things you can do that will save gas. It doesn’t take too much to save a gallon each week:
- Using a shopping list and go to the store once per week or once every two weeks.
- Invite your neighbor to go shopping with you. (If they don’t drive their car, you’ve saved gas.)
- Car pool to work. Average commute distance in the US is 32 miles per day. If you can car pool one day, you will have saved your gallon of gas for the week. With gas prices they way they are, it should be easier to find people willing to car pool than 5 years ago.
- Work from home. If you can work from home one day per week or even one day every other week, it will result in tremendous gas savings.
- Defer trips. Keeping a list of places you need to visit and then batch them together will save you time, but it will also save you gas. Just keep a “shopping list” of places you need to go for the week and look for ways to batch them together.
- Local vacations. Spend 15 minutes looking for nearby vacation spots. If you live in Florida and want to go skiing, this isn’t going to work, but it is easy to overlook great opportunities in your area of the country simply because you aren’t looking.
- Ride a bike or walk. This isn’t a good option for a 100 mile daily commute, but riding your bike a few miles to the post office or on other errands can contribute to saving gas and to your health.
The biggest thing you have to do to save a gallon of gas each week is to simply think about it. Notice that none of these suggestions are really stopping anything important. There are a lot of opportunities without really changing your habits or lifestyle. It is just a matter of spending a little bit of effort to minimize the time you spend in your car.
The great thing about trying to save one gallon of gas per week is that it saves you money and it saves you time. Depending on where you live it will probably saving you over $175 per year at current prices. That may not seem like a lot of money, but if you can make $175 with very little effort it is well worth it. In fact, if you figure in depreciation and maintenance on your car, reducing your driving by 25 miles per week is probably going to save you closer to $676 per year.
This isn’t the first time we’ve had a high oil prices. Back in the 80s there was a gas crunch. People reduced consumption and switched to more efficient vehicles and it drove the prices back down. I have a 1986 BMW 325e. It is my understanding that the “e” stood for “efficient” and was built in response to the gas shortage. It can get 32 MPG on the highway which still isn’t bad for a car that was made over 20 years ago.
I can’t tell you how much a 3% reduction would lower gas prices. But I can tell you that reducing demand is going to get us a lot further than any temporary tax break or other short term fix.
While it doesn’t enormously change your analysis, oil is not simply a market commodity, but a *futures* market commodity. That is, the price of oil on the market is not only influenced by current supply and demand, but also by what speculators a few months ago thought supply and demand was going to be and what speculators now think the supply and demand will be in the future….
So I’m confused: if everyone reduces their gasoline consumption by 1 gal per week, gas prices will go down because the demand for crude oil will go down, but then OPEC decides to reduce the amount of crude oil they export, and prices go back up, right?
@Ryan – Good point, but isn’t that still pretty much the same as the stock market because of the way options work?
@Carl – They might decide to reduce output. However right now, they are pretty much at their maximum production, so they couldn’t increase production significantly even if they wanted to. People like to blame OPEC, but demand is so high right now that OPEC isn’t really doing anything to control the output.
As long as demand remains high, OPEC can stay together because everyone is making a lot of money. If the price goes down, countries will start breaking from OPEC because they will want to sell more oil than what OPEC says they can sell. I can’t find the reference but I believe this happened in the late 80s.
In fact having high prices right now is likely to make it harder to keep OPEC together if demand goes down. Countries become addicted to the oil cashflow. If demand goes down significantly and OPEC tells everyone to cut their output by 50% there is likely to be a few countries who decide they want to bring in more money by selling more oil regardless of what OPEC says. Once one country does this others are likely to follow.
The point is that if you can do everything you need to do, not be inconvenienced, and use 1 gallon less per week, you can help drive the price down. If we artificially drive the price down for a few months and make demand go up, we will end up with higher prices–even if it is lower for a few weeks.
@Mark – My point is just that some part of the price of oil is not pure supply and demand, but the market’s current perception and future speculation on supply and demand.
If an oil speculator comes to the conclusion that the supply of oil is going to decrease dramatically 3 months from now and buys a whole bunch of oil futures on that basis, the price of oil will go up – REGARDLESS of whether or not that belief is true. The speculator will eat a big loss if the supply actually goes up or demand decreases.
Furthermore, while the bottom will drop out eventually, even if there is no change in ACTUAL supply and demand, a futures market can maintain a sustained period of price increases if speculators buy futures on the belief that the price will go up, which causes the price to go up (increased demand for futures), which leads to more belief that the price will go up, and so on.
Another option is to get rid of gas guzzling vehicles. The media here in Los Angeles are full of stories about people trading in SUVs and how hard it is for anyone to get rid of one these days.
Six years ago I bought a Vespa ET-4. I now use that for as many trips as I can (which is any trip that doesn’t involve ferrying large objects). Even using premium gas I’ve never paid more than $6 to fill the tank. Contrast that with $60+ to fill up the car I otherwise would be driving. A scooter might not be practical for everyday use in some climates, but out here it’s ideal, and we see more and more of them on the road as time goes by.
@Ryan – So it is like supply and demand with time machines. :) I see what you mean though. The belief that prices will be high can keep them that way longer in a futures market–even if demand actually drops. Good point.
@Infomom – I like the idea of a scooter, but I’m not so excited about the safety. I’d like to see some ultra small cars that basically use a scooter engine, but have some type of frame to add protection. The smart cars are kind of along the lines of what I think I’d like.
Mark,
In addition to the effects of speculation, which most good analysts credit with adding $20-35 per barrel to the current price, we also have the very large issue of the percentage of demand that is coming from developing economies — especially India and China. It is growth in oil consumption by these countries that has kept speculator interest in the oil market alive in the face of decreased demand in the U.S. and what looks like a recession here (which would normally spark a sharp selloff in futures). While there’s not much we can do about demand growth elsewhere, I agree with you that we ought at least to try the virtues of controlling domestic demand.
Curt
@Curt – the developing countries raises a very interesting issue. In the past the majority of the demand for gasoline came from the United States. It looks like this could change in the future. Right now I think the majority of oil is still coming to the US, so lowering demand here should lower the prices. However in the future this might not be the case.
I’ve got a great idea. We have so many ways to become less dependent on foriegn oil. For years the republicans have tried to drill in ANWR for oil in an area that is so small and this has been blocked by democrats and enviromentalists (not to mention the offshore opportunities). No one wants on the left wants to entertain this idea because they believe that this betrays their own belief system. It is this belief system that has gotten us in this quagmire. I wonder how much fuel is spent on getting the crude from the middle east to the US and other countries. Why aren’t enviromentalists decrying the middle eastern countries environmental disasters. The answer is they are chicken and always hit the soft targets and avoid the root issues thinking that since they have done something, they have done the right thing. Activity alone doesn’t guarantee success.
We only empower OPEC and the terrorist nations by buying their oil. Why not drill in the US and (notice the word and) look for alternative ways of transportation and new fuel types or sources? Why don’t you libs pressure on the democrats to solve the energy problem by working with the oil companies instead of trying to put them out of business in the US? Let’s not forget that the dems are in control of congress and everything is out of control. Hold their feet to the fire. Why do you think that pulling the gun out of the holster and shooting your foot is the answer?
I am for lowering fuel consumption and finding alternative fuels and even alternative types of transportation, but my business relies on trucks to move heavy items. Not every one works in an office. Someone with a truck built that office building or home that you work out of. Incidentally, I have already cut my fuel consumption by approx. 2/3 in the past 2 years. You can control demand only so much then you have to shut down. Is that what you want to do? Shut down America. Some are so ticked at our president that they are not thinking right. Get out of your city and see the rest of the nation. It is a big country and a great country and we are not perfect, but we are good people doing our best and the thugs are among us, but we can get past that garbage and regain common sense.
Mike
I am still curious about the stock markets part in all of this. I know nothing about futures or how it all REALLY works other than it involves money , investors and poeple wanting to make more money. Am I wrong in thinking it is investors putting money in the furures market gambling that the price will go up , thus making them more money when they sell , thus driving the price up?
Please tell me I am wrong , because if I am write , then really the price of oil is driven not only by demand for it , but also by investors wanting to make a buck off of it at everyone elses expense?
Is this correct or incorrect understanding? Because if it is , it means our very own greed is driving the price up as well as the demand.
Please let e know.
Thanks , Gilbert
@Gilbert – I think a better way to look at it is this: Prices are driven by demand, but they are also driven by projected future demand. If oil is at $130 a barrel today and I think it will go up to $145 in 30 days. I might make an agreement to buy oil for $135 over the next 30 days.
If everyone does this, then the price may stay high (temporarily) even if the demand goes down. However, as far as I can tell this is only a short term thing and eventually the demand will determine the price.