Thursday, November 03, 2005

An explanation of gas price fluctuation

This article is very informative. It explains, in simple language, why gas prices rise quickly, but fall slowly. At least as far as the retailers go. A superbrief summary is:
  • When oil prices go up, the manufacturers raise their price, and retailers must pass the increase along to customers.
  • When oil prices go down, retailers do not usually lower their prices until competition forces them to. Which means it will be some time after the oil company's price goes down. Depending on the local market, there may be a fairly large delay.

What the article doesn't discuss, however, is what the picture looks like from the point of view of the oil companies. They have the same problem (rising prices must be passed along, competition causes prices to go down), but they have an additional complication - futures trading.

Oil, like all commodities, is deeply involved in futures trading. A future is like a stock option. You pay a premium up front and get a locked-in price (for a maximum amount, for a time limit, of course). You can exercise your future to buy (or sell) oil at that price, if you want to.

Futures are used by speculators to leverage investments. Instead of buying and selling oil (where you need to pay for it all and store it somewhere), you instead buy and sell futures. If you buy a future for buying oil, and the price later goes up, you can exercise the future and immediately sell the oil at market prices and take a profit. If the price later goes down, however, you've lost the premium you paid for that future. Similarly for futures for selling oil - if you buy one and the price goes down, you buy oil at the market price and exercise your future to sell it. If the price goes up, you've lost the premium.

As for the other side of the equation, people sell futures to buy and sell. When you do that, of course, you are bound to buy/sell oil at the future's price if the future is later exercised.

Oil companies use futures in order to make their finances more predictable. In addition to buying oil on the open market, they also buy futures for buying oil. If the price goes up, they can exercise these futures and buy at the price they've budgeted for. It doesn't keep the price down, because new futures will be at a higher exercise-price, but it does allow them to keep their budget predictable.

When the price of oil goes down, however, they abandon the futures and just buy on the open market - because that price will be lower. But they have to eat the cost of buying the now-abandoned futures - those premiums are not refundable. So their costs can't come down immediately, which is why the prices they charge won't come down immediately either. When prices stabilize, they will once again resume buying oil with their futures, and the prices they charge will lower to the new equilibrium point.

In brief: prices go up immediately because the price of futures goes up immediately. Although the prices of futures will come down immediately, the oil companies have to absorb the cost of the abandoned futures, which introduces a delay when prices come down.

Is there an alternative?

If using futures creates this problem, why do they do it? Why not just buy oil at market prices and avoid all this nonsense?

The answer is that oil prices fluctuate daily, and often unpredictably. If every shipment of oil is a different price, it creates a lot of uncertainty in the budget. Companies would have to compensate for this by either keeping a stockpile of oil (to buffer out supply fluctuations) or take a higher profit margin (to buffer out price fluctuations.) These would cause prices to go up (to pay for storage or to make the higher margin). And unlike what happens with futures trading, these price increases would be affecting consumers all the time, not just when commodity prices are on the downswing.

1 comment:

Jessica said...

Gas prices are ridiculously high. It's such a rip off!