Philadelphia Reflections

Oil Bubble

The cost of gas at the pump has soared, and conspirators are suspected. But, awkwardly, nice respectable pension funds and university endowments may be responsible.

Although gasoline in the U.S.A. costs only half what it does in France because of their taxes, prices at our friendly local pump have nearly doubled in a year. Scoundrels are suspected. The major oil companies have no trouble showing they are not profiteers but victims of high prices of crude oil, but not everyone believes them. The oil consumption of developing nations is assuredly increasing but not enough to cause prices to jump this much; the oil-producing nations are pumping about all the refining system can absorb; and American gasoline consumption is trending down a little, not up. So who's the speculative villain, here? An offshore trader named Michael Masters pointed out to befuddled congressmen at one of their show-trial hearings that the marketplace for crude oil is mainly divided between actual producers and actual consumers, plus a buffer of middle-men who may buy and sell but neither produce nor consume. Normally, middlemen are involved in about 20% of crude oil transactions. Recently, they constitute almost 80%. Aha!, we are starting to get somewhere.

Lukoil Gas Prices

There will be, however, little political mileage in hounding these speculators, because they indirectly represent mostly retirees and grandmothers whose purchases are not predatory but prudent. Life savings (encouraged by Congressionally created tax shelters) have accumulated in pension funds and custodial accounts of one sort or another, run by professional managers. Since the stock market is down over a thousand points and bonds look risky, these pooled funds have accumulated cash. Moreover, falling interest rates drop the value of the dollar, and real estate is presently a special catastrophe. So essentially only one investment asset class is rising in price -- commodities. Gold is a commodity but has already seen a big price runup, while agricultural products are seasonal. So, essentially, the huge global tidal wave of liquidity has exhausted one safe harbor after another. The current soft spot, where the tire bulges out, is the price of oil.

It has long been difficult to invest in commodities as an asset class, but modern investment theory devoutly believes in combining unrelated asset classes, and continually searches for more of them. So, investment managers have lately created index funds to facilitate investing in commodities as a general class. These funds are more costly and complicated to run than index funds of stocks and bonds, and there is rent to be charged for scarce expertise in a non-traditional field. Consequently, the low-hanging fruit for managers of commodity funds has been to solicit and even limit access to non-profit endowments, pension funds, and sovereign wealth funds. All of them are cash heavy, and almost all of them are touchingly trustful. So, a very large pool of money has switched from cash to commodities without much notice by its ultimate owners, and the main commodity at the moment is oil. These pensioners and rentiers through their surrogates don't want to burn oil, they want to own oil. But the effect is the same; increased demand with constrained supply leads to higher prices.

An illustration makes the point quite simple. An oil tanker filled with many thousands of barrels of oil takes five days to go from Venezuela to Philadelphia, somewhat longer to come from Africa, and considerably longer to go from the Persian Gulf to Japan. But even in the mere five day trip from Venezuela, it is quite common for owners of the cargo to change hands ten or twelve times, each time at a slightly higher price. The ship plows along uneventfully, but ownership of the cargo is held anywhere in the world and transferred over the Internet; the captain of the ship could care less. There's only one buyer in Venezuela and one seller in the Delaware Bay, but five or six other parties have the feeling they owned the cargo. The value of the cargo could well rise by millions of dollars in the interval between sale by the producer of the oil in Venezuela, and purchase by the refiner of the product in Philadelphia. It's hard to say whether aggregate demand has risen, but virtual demand certainly has and is capable of affecting the price. With this picture in mind, the aggregate total produced or the amount refined, or the amount burned in SUVs, are sometimes irrelevant to the price at the pump. And the speculative owners of the money involved can be blissfully unaware, or even vocally critical of what they are doing.

Where this will lead depends on whether the imbalance of true supply and virtual demand is a bubble or merely a sign of inflation. Another way of describing the matter is to ask what the "real" value of crude oil is. Some pretty experienced oil traders believe oil is only worth $45 a barrel, but the larger consensus is that it would sell at $80 rather than $140 if the "speculative" element were removed. Essentially, this analysis suggests that oil has moved from $15 to $80 because of inflation, but the further move from $80 to $140 is a bubble. The distinction is not whether consumption is out of balance with production, but whether the supply of oil and the supply of money are out of balance. If that's approximately accurate, all we need to worry about is the Federal Reserve, the European Central Bank, and the likes of George Soros. Always remembering the destructive potential of wars, hurricanes, and presidential candidates.

One final point needs to be made to the skeptical customer, encouraged by politicians to believe big oil companies headquartered in some other state are ripping him off. Without resorting to statistics and computers, the gut feeling of most motorists is based on quick notice that gasoline prices are asymmetrical. That is, they go up promptly when the price of crude oil does, but slyly are more sluggish in going down after a fall in crude oil. Asymmetry is quite verifiably a fact of the gasoline marketplace. However, it is not true of wholesale gasoline prices, which track the price of oil quite closely, both up and down. The observed delay in adjusting prices downward in response to wholesale gasoline prices is due to your friendly local retailer. When there is a sharp drop in wholesale gasoline prices, the retailer finds himself with gasoline in his underground tanks which tank trucks delivered earlier at a higher price. Until that inventory is exhausted, the retailer is reluctant to lower prices below his cost. That normal reluctance is heightened when prices are jumping up and down frequently, because it becomes possible for him to sell gas, both below the cost of what is in his tanks, and below the cost of new gas that hasn't arrived yet. For the retail gas station, cautious behavior isn't speculation, it's survival. And in case you believe that retail gas pumping wallows in unjustified profits, notice that the big oil companies are now doing their best to sell off the retail stations, after decades of buying them up. That probably accounts for all those new names you recently see on the old gas stations, possibly reflecting penetration of American domestic markets by Russians, Venezuelans and other enemies of democracy. Possibly so, but more likely it just reflects a decision by big oil to let someone else experience the hostility. Call it, if you like, Yankee ingenuity.

Chairman Bernanke of the Federal Reserve refuses to believe present high oil prices will persist. Although motorists mutter about it, the price of oil is excluded from the present calculation of America's inflation rate, which has been renamed "core" inflation. To simplify a little, core inflation reflects wages. In Bernanke's view, we don't have inflation until we have inflation expectation; and he chooses to measure expectations by the degree to which employers raise wages, in response to protests from employees. When wages go up, consumer spending also goes up, which forces up the price of goods. If rising prices of goods provoke another round of wage inflation, things are spiraling out of control. But if the price of goods like oil goes up without provoking a rise in wages, it's something else, maybe stagflation. Or, one can hope, a prediction that the price of oil will soon come back down where it belongs.

Originally published: Wednesday, June 25, 2008; most-recently modified: Wednesday, May 29, 2019