Do Oil and gas prices move together?
Standard 5 Individuals, businesses and governments interact and exchange goods, services and resources in different ways and for different reasons; interactions between buyers and sellers in a market determines the price and quantity exchanged of a good, service, or resource.
Benchmark- 9.2.4.5.6 - Explain how changes (shifts) in the demand and supply of an item result in changes in its market price and quantity; explain how these shifts can lead to changes in prices and quantities in other markets.
Have you ever wondered why gasoline stations raise their prices in response to fears about future supplies of oil? You may have thought to yourself, "I know the gasoline in the station's underground storage tank was purchased before the world price increased. How can they raise the gas price now? The gasoline market must be rigged."
In fact, gasoline stations should raise their prices to reflect increased future costs of replacing their inventories. Prices act like engine or voltage regulators—they automatically speed up or slow down the flow of the commodity in order to maximize performance, or what economists call allocative efficiency. (Consumers get the goods for which they are willing and able to pay.)
Oil and Gas, Here and There, Then and Now
To understand why U.S. gas prices respond now to things that might happen in the future, halfway around the world, one must understand how spot and futures prices for storable commodities, such as oil or gasoline, are related to each other.
The cost of oil comprises about half the cost of gasoline, but oil is the most volatile component; other factors, such as taxes and profit margins, do not change often.
The figure above shows that while gasoline prices can diverge from oil prices for short periods because of seasonal demand, tax changes or other reasons, the two prices are closely linked over longer periods.
Because oil can be transported anywhere, trading on global spot and futures markets determines the global price of a given grade of oil, aside from local taxes and transportation costs. Oil can either be sold for immediate delivery or stored for sale in the future; so, firms adjust their inventories in response to news about the future supply and/or demand for oil.
Because oil is such an important component of gasoline, wholesale gasoline prices react instantly to changes in oil prices, including those caused by expectations of future events. The price at your local gas station will change nearly as quickly as the wholesale price.
Let's see how two hypothetical competing gasoline stations in a small town might react to a sudden increase in the price of oil. On one quiet morning, both the Conch Gas station and the Pegasus Gas station were charging $1.999 per gallon of regular gasoline. They each had bought their inventories a few days before at a cost of $1.48 per gallon. With federal, state and local taxes combining for 50 cents per gallon, each station calculated that it would make about 2 cents per gallon at a retail price of $1.999.
During the late morning, news of an unsuccessful terrorist attack on Saudi Arabian oil fields spurred widespread fears of cuts in future oil supplies. As frenzied trading on exchanges in New York, London and elsewhere bid up the world price of oil, the station owners learned that wholesale gasoline prices for delivery next week had increased by $1 per gallon. Both owners raised their prices to $2.99 per gallon.
Despite much grumbling at the price increases, sales at the Conch Gas and the Pegasus Gas stations proceeded much as before—both stations sold out their existing inventories right on schedule and then took delivery on a new load of gasoline at the new, higher wholesale prices. The station owners made a tidy, unexpected profit that week—$1.02 per gallon.
Answer these questions:
1.What is the market-clearing (equilibrium) price for gasoline?
2. At this price, how many gallons of gasoline will be bought and sold? (45 million gallons?
3. How do we know that this is the market-clearing price?
4. At $2.25 per gallon, how many gallons are consumers willing and able to buy?
5. At $2.25 per gallon, how many gallons are producers willing to produce and sell?
6. At $2.25 per gallon, will a shortage or a surplus exist?
7. What will happen to the price as a result?
8. At $3.50 per gallon, how many gallons are consumers willing and able to buy?
9. How many gallons are producers willing to produce and sell?
10. At $3.50 per gallon, will a shortage or a surplus exist?
11. What will happen to the price as a result?