The consensus belief among Americans is that the cause of current gasoline prices is "America's addiction to oil," suggesting that our demand is increasing faster than the supply. This belief is fed by almost every member of the media as well as countless politicians, including the current presidential candidates. Some even elaborate to saying that world's demand for oil, mostly coming from China, is causing a shortage and responsible for the current price levels. Members of the democratic party take the topic a step further and accuse the oil companies of gouging and price manipulation. They in turn use this as an excuse to propose ridiculous taxes on the oil companies, but I will get to that in a subsequent post.
The increase in global demand for oil is an undeniable reality. That being said, this demand increase has relatively little to do with the recent surge in prices. The true driver of the recent oil prices is very simple: the value of the U.S. dollar. This is also true of the rest of the commodities that have seen recent surges, including food. There is only slight simplification needed to make this phenomenon readily understandable for everyday Americans that are not familiar with futures markets.
The prices of commodities, including oil, are denominated in U.S. dollars. Meaning that if you wanted to purchase a barrel of oil, a bushel of corn, or an ounce of gold you would need to pay for it with American currency. It is simple to see then, that when all else is held constant, if the value of the dollar decreases, then the number of dollars you would need to spend to purchase that same barrel, bushel, or ounce would increase by that same amount. This is the concept of inflation. (For those wondering why the CPI, the federal government's primary inflation yardstick, only registered a .3% rise in March while oil saw about a 4.5% rise over the same period, I will explain this dislocation and the problems with that indicator in a subsequent post.)
Take a look at the following charts:
On top is a weekly price chart of the U.S. Dollar Index over the past 2 1/4 years- it tracks the value of the dollar. The lower chart reflects the continuation-adjusted weekly price of the Light Sweet Crude futures contract- the price of oil. It doesn't take an economist to see the obvious inverse correlation between the two. You can see the same inverse relation between the recent chart of the dollar and the prices of most commodities.
This is not at all to say that the weak dollar is the only thing influencing the current pricing of oil. I am simply showing the fact that it is the single largest and most important factor. Now that you see the cause and effect relationship between the value of the dollar and the price of oil we can translate this into gasoline prices.
Shifts in the pricing of crude oil are almost immediately translated into identical moves in the price of refined gasoline on the wholesale end. These shifts then take anywhere from a few days to several weeks to fully reflect in the retail price of gas at the pump. This is because when the retailer, a gas station, receives a new shipment to replenish their supply at a higher price they must sell that gas at a proportionately higher price to maintain their margins. In most cases the gas station will then sell the remainder of that shipment for that price and not make major adjustments in price until they receive their next shipment, hence the price lag at the pump.
With this supply chain in mind, starting with the price of crude oil, let us now make a few calculations. First take a look at the same charts of the dollar and crude oil, respectively, extended monthly over the last 10 years:
Focus your attention to the points highlighted by the red line and the circled areas. This was the end of 2002 and just before oil prices began their long climb up from $30 to $125. Notice that this coincides with the point at which the dollar started its slide from 105 to almost 70. So now let us evaluate the price of oil and gasoline if the dollar was not allowed to depreciate 33%. Take the current price of oil at $125 a barrel and multiply it by .67 to remove the effect of the weak dollar and we arrive at $83.75- the price of oil as dictated by supply and demand. We can then take the national average gas price at the pump of $3.72 and use the same calculation to arrive at $2.49. Granted these prices are still historically high, except when compared to the oil crisis of the early 80's, but the prices we just arrived at are what they would be if the Fed did not allow and perpetuate weak dollar policy. (The dollar and the actions of the Federal Reserve will be recurring topics that I will elaborate on in future posts, I will not go into detail here because the focus of this post is the simple relationship between gasoline prices and the value of the dollar as has been illustrated.)
In conclusion, my goal in this post was to make the reader aware of the real primary driver of current gasoline prices. The main importance being that not one of the 3 presidential candidates has put much, if any, emphasis on strengthening our dollar as a means to getting energy prices back down to acceptable levels. The gas tax holiday, more taxes on oil companies, taking away drilling subsidies, carbon emission caps, none of these proposals or gimmicks will have any real positive effect on long term prices, and some of these will lead to higher prices. My next post will tackle the subject of taxes on oil companies and will build off of some of the ideas we have just covered. The takeaway: as Larry Kudlow states repeatedly, "The candidate that gets to the strong dollar first will get it right and take the presidency."
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