A curious thing is happening to the American economy once again. Everyone who has taken Economics 101 knows that price is supposed to be determined by supply and demand. If supply goes up, and demand goes down, then prices should fall. If demand goes up, and supply goes down, then prices should rise. However, the crude oil market introduces another factor into the equation, which may be driving gas prices in America up despite increasing supply and decreasing demand.
The average price of gallon of unleaded gasoline is currently at $3.57 per-gallon nationally. The average was $3.17 one year ago, and up 90% from three years ago. Gas is selling for over $4.00 per-gallon in some areas, and there are fears that prices could soar above $5.00 per-gallon once the summer driving season starts.
The media is largely accepting these increasing prices as a natural part of the economy, and focusing on the possibility of increasing drilling sites as a potential solution. The problem with this narrative is that domestic oil production is already at an 8-year-high. Demand for petroleum in the United is at the lowest level since 1997, due in part to increasing gas-mileage standards for automobiles and increasing reliance on alternative fuel sources in many industries. If the economic law of supply and demand held true, gas prices would be dropping.
But alas some say the increasing gas prices are in response to fears about future supply and an assumed increase in domestic demand. The problem with this narrative is that it just does not match up with the facts. Domestic oil production is projected to surge by 1 million barrels per day over the next decade. In addition, demand is expected to continue to fall due to increasing efficiency and reliance on other fuels. By some projections, which are by no means considered outlandish, the United States could be completely energy independent by 2022.
Worldwide the picture is not much different. The rise of the Chinese economy will work to increase demand in the long term future, but the best experts expect more than enough supply-side flexibility throughout 2012. Iran cut off France and Great Britain from their crude oil flow, but Iran’s contribution made up less than 1% of the total crude oil supply in these markets.
What is not taught Economic 101 classes is the idea of speculation. In the oil market speculators are allowed to buy “future oil” which has not even been produced yet. If speculators spend a great deal on this future, it can drive up the price even if the supply and outside demand stay the same. Some argue that speculators themselves are part of the demand. The problem with this assumption is that speculators do not really need the oil, they are simply bidding on the oil in hopes of making a future profit by selling it at higher prices later. A normal consumer would start to cut back their spending once prices rise. Speculators only benefit from rising prices, as it means they can sell their contracts for an even higher profit in the future.
Lest anyone this is all just theory, over the last month speculators have spent about $11 billion on futures contracts for oil. Monday futures contracts rose to $121.15 per-barrel of oil, the highest level since May. All of this is based on nothing more than the assumption that oil may be more scarce in the future. In fact, the rise in prices may not even be based on that assumption. There is nothing preventing speculators from causing a spike in oil prices merely to increase profits. Meanwhile, the American consumer suffers, and the media discusses opening new drilling platforms that would not be able to produce new oil for years.
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