If you are like most Americans, then you keep a close eye on the prices at the pump as we approach road trip weather. Tesla owners need not apply! Ever wonder what trends affect the price of gas? It obviously all starts with oil. Oil is a very versatile commodity whose uses range from energy to plastics to agriculture, thus it is a highly sought-after substance. From an energy standpoint, it’s easy to see why it’s so important. At the time of writing this, May 2018 Crude Oil futures were trading at $66.20 per contract. One 42-gallon barrel of oil contains about 5.8 million British Thermal Units (btu) of energy. To put this number in perspective, it takes about 75 btu to boil the water for your morning cup of joe. From an electricity standpoint, 1 barrel is the equivalent of 1,700 kilowatt hours. Let’s ask the question then, is that barrel of oil worth that contract value of $66.20? One way to look at it is by comparing the energy available in oil to that of standard labor. If a horse labored a standard 40 hour work week for 50 weeks out of the year, it would require more than a year’s time to produce the same amount of energy as a barrel of oil. A fit human adult can sustain about one-tenth of horsepower, so with the same standard work week, it would take a human longer than 10 years to equal a barrel of oil. Compared to the cost of quartering a horse and paying for human capital, that barrel of oil is looking pretty efficient right about now! Oil and oil products also have the advantage of being easily transferred and easily combustible, which is why they play such a key role in manufacturing and transportation.
Simple stated, oil has a tremendous amount of importance and demand, even as cleaner alternative forms of energy are becoming increasingly mainstream. The price of oil then becomes an important input when talking about the price of gas. Also, looking at factors that affect the price of oil are key to seeing what trends are present. The first 4 relate solely to the price of oil with the last two being factors involved in refinement.
The first factor is geopolitical risk and major threats to the world’s oil supply. For example, the 12 countries that comprise OPEC (Organization of Petroleum Exporting Countries) are mainly located in volatile regions of the world like the Middle East, Africa, and South America. These countries alone control roughly 80% of the world’s oil reserves and because of this, are actively engaged in market manipulation to control the price of oil. After all, they have an interest in keeping prices high, right? Instability in these regions will increase the risk of production thus driving up oil prices.
The second factor is the ups and downs of the oil market’s supply side as a whole. While OPEC is a major player in the world’s oil prices, it’s member countries aren’t the only producers. The three other major players in oil production are the United States, Russia, and China. New technologies have helped produce more oil and this is especially true in the United States where fracking has unlocked shale reserves in places like North Dakota, Colorado, and Oklahoma. Decreases in regulation have also helped open up more reserves to production. In the first 200 days of the new administration in 2017, the White House signed 42 Executive Orders, most of which aimed at reversing Obama-era regulations. Increased production in the last few years here in the US has helped lead to lower prices in oil overall, even as OPEC has tried to cut back on production. According to the EIA (US Energy Information Administration), projections for 2018 US crude oil will average 10.7 million barrels per day (b/d) which would notch a new record against the previous watermark of 9.6 million b/d set in 1970. You can view these figures at the EIAs website in their Short-Term Energy Outlook .
The third factor is the demand side of the equation. New markets and rising demand for oil in countries that are rapidly transitioning to modern societies and economies will also drive the price of oil, pun intended! Think of China as an example, with massive gains in its economy over the past two decades, the Chinese middle class is set to explode (and already doing so). According to a study by McKinsey & Company, in the year 2000, just 4 percent of the urban population was considered middle class. By 2022, that figure is expected to increase to 76 percent! In 2015, it was estimated that China had an urban population of about 730 million people. If that number stayed constant (which it will only grow) than that means by 2022 over 550 million people in China will be considered middle class. Do you think some of them will be driving a new car?
Number four is largely an affect of trading. Bubbles in the market can appear due to sheer speculation. Remember 2008? The housing market and stock markets weren’t the only ones to see adverse reactions to the crash. The price of oil surged at this time to a record of $145 a barrel as traders turned to oil futures to make money even though demand was falling and there was a glut in supply. The price of gas soon followed suit and shot above $4 a gallon.
Refineries themselves play an active role in the movement of gas prices too, which is what factor number 5 is all about. Prices for gas generally tend to rise in the spring and summer as more American families go on vacation. The increase in travel, thus increases demand and prices rise. The other reason that prices tend to rise during this time is that the actual ratios of ethanol change in the gas formulations. Refineries do this to help combat the effects of global warming which are heightened during the summer. To prepare for these changes, they gear up in the spring and will typically shut down for maintenance and to switch their formulations to the higher ethanol blend. The shut downs are generally publicized but if too much supply is cut off, prices can rise. As the fall approaches, prices usually drop as demand tails off. The price of gas can also be adversely affected by natural disasters, like hurricanes for example. The damage to refineries from hurricanes can spike the price of gas because most refineries in the United States border the Gulf of Mexico.
The final factor which is fairly easy to measure is the effect of taxes. For example, here in California Governor Brown signed into law a new gasoline tax of 12 cents per gallon in early 2017 that went into effect November 1 the same year. That brings the total to 39.8 cents per gallon for Californians. Add in the federal gas tax of 18.4 cents and that makes a grand total of 58.2 cents in excise taxes per gallon. At $3 a gallon that represents close to 20% of the retail price. Unfortunately for us Californians, it’s only forecasted to get worse from this standpoint. On July 1, 2019 the state tax will increase another 7.5 cents bringing the combined state and federal excise tax to 65.7 cents per gallon.
While these are just six of the main factors, it’s easy to see that forecasting the price of oil and the price of gas is no easy task. The EIA does a great job at looking at these (among other factors) to come up with their own short-term forecasts to show a broad picture of where prices are headed. If you’re curious, check it out at the link mentioned with the second factor!
Written by: Griffin Sheehy, Trading and Planning Associate