Don't Blame Speculators: Why Gasoline Prices May Stay High

Last Updated May 11, 2011 1:07 PM EDT

U.S. consumers are hopping mad about the price of gasoline, and the Obama administration has responded with forming a multi-agency government commission to investigate into whether the reason for high prices is "illegal speculation" in oil on the futures markets. Whatever they find, or don't, probably will not matter to the high prices you are certain to pay at the pump this summer.

Many years ago I wrote a term paper on commodities futures, and in the process I read about the history of sudden high prices in commodities being blamed on speculators. For many years, "speculators" have been portrayed as shadowy big money figures who don't have a genuine interest in the commodities they trade in (as do producers or consumers of grain or meat or whatever), but just whip the markets into a lather and then take big profits.

I have never bought into the idea that speculators themselves drive the markets. OK, they may have an influence on the direction of the markets from time to time, and they probably do increase the volatility of markets, that is, the random fluctuations that occur around the average price. In the end, however, what sets prices is the supply and demand for the physical stuff.

Today, the factor setting the price of oil, and lots of other goods, is the tremendous demand from China -- about 10 percent of world production. (I mentioned this in a post last week on inevitable rises in commodities prices. By the way, a great post, if I do say so myself, but one that did not get much attention.)

In The New York Times, Paul Krugman made a sensible point on speculating and commodities, dating back to 2008:

...I have two words for them: iron ore.
You see, iron ore isn't traded on a global exchange; its price is set in direct deals between producers and consumers. So there's no easy way to speculate on ore prices. Yet the price of iron ore, like that of oil, has surged over the past year. In particular, the price Chinese steel makers pay to Australian mines has just jumped 96 percent. This suggests that growing demand from emerging economies, not speculation, is the real story behind rising prices of raw materials, oil included.
That's not to say that there isn't some inflation of prices from speculators, and certainly the sharp rises and falls could come from non-physical buyers.

But that is probably moot for now, due to another factor in the energy markets -- cracking spreads. This is the difference between the value of a barrel of oil that goes into a refinery, and comes out in the form of gasoline and heating oil. Cracking spreads are very wide now, as in this graph from Bank of America/Merrill Lynch, via the Financial Times.

The gap is approaching $40 per barrel today. A more normal level is somewhere between $5 and $20 per barrel. Cracking spreads followed the same pattern in 2007.

I don't know why spreads were high then, but today there is a shortage of refinery capacity, and there are fears it will get worse if the floods on the Mississippi River knock out refineries downstream. From Reuters:

Traders eyed a fire at Chevron's Pascagoula refinery and Mississippi River flooding near several U.S. refineries, though none has been impacted.
"A premium is coming in on the potential for flood damage, not just for the refineries higher up on the Mississippi, but the refineries near the mouth that were flooded by (hurricanes) Katrina and Rita," said Richard Ilczyszyn, senior market strategist at Lind-Waldock in Chicago.
To sum it up, here's the FT again, quoting analyst Olivier Jakob at Petromatrix, offering little hope to those thinking that falling prices for crude oil will help lower gasoline prices, and put some money back in consumers' pockets:
Anyone that feared demand destruction when WTI [crude oil] was at 115 $/bbl should continue to fear. The price of crude oil might have dropped like a rock last week but it will translate to almost no change in the price of gasoline at the pump since the fall in crude oil prices has been replaced by a surge of the gasoline crack.
If WTI was to move back to the price level of last Tuesday then we would be even deeper into the demand destruction zone due to the 10$/bbl increase in the gasoline crack since then. Bottom line: for the US driver, nothing has changed; or rather the prices at the pump are at risk of getting even worse than they were a week ago. Crude oil prices might be more than 10 $/bbl lower than a week ago but it will not translate into higher disposable income for US consumers.