Some Perspectives on Gasoline Prices

By Jed Smith, Managing Director, Quantitative Research

For the last few months I have found the bi-weekly fill-up at the gas pump to be an increasingly traumatic experience. Prices are down a bit right now, but I feel the pain. 

Changes in the price of gasoline have immediate relevance to the housing markets in terms of the amount of after-tax/after-gas income consumers have available, in terms of impacts on where to buy a house, in terms of consumer confidence-in a major way, and in terms of other purchasing decisions associated with the housing process. The National Mood right now is not good! Consumer confidence is down, and this is probably impacting some potential buyers. 

There has been a lot of loose talk about $200 per barrel (and up!) oil, so some commentary seems to be in order. I didn't really understand how bad some people felt until I read through e-mails from Realtors® about the cost of travel to show homes. Gasoline prices have been a growing problem for the last few months. Right now we have a modest respite, a leveling-off and slight decline. However, there is still a lot of concern on the subject of what the future will look like at the pump.

A few days ago I found an "open letter to all airline customers," signed by twelve (!) airline CEOs, urging us to write Congress in opposition to oil speculation:

Since high oil prices are partly a response to normal market forces, the nation needs to focus on increased energy supplies and conservation. However, there is another side to this story because normal market forces are being dangerously amplified by poorly regulated market speculation.

The CEOs told me that:

The nation needs to pull together to reform the oil markets and solve this growing problem. We need your help. Get more information and contact Congress…

Now, I know that all of us-airline CEOs as well as those of us trying to survive in the back rows of coach-are in this together (how could it be otherwise with 31 inch leg room, $9 dollar in-flight meals, missed connections, and sometimes $2 for a soft drink, which at approximately $20 per gallon based on a 12 ounce can is substantially more expensive than jet fuel), and I want to be helpful. So, instead of contacting Congress, I thought I would mention some of the concepts found in "Overview of Economic Terms" on the NAR Research page.

The concepts of Supply and Demand are immediately relevant to the analysis of oil prices. The demand factors putting upward pressure on the oil markets include increasing oil demand from developing economies (particularly China and India), increased petrochemical usage (e.g., garbage bags), transportation (most of us need to drive!), the growth of oil positions in various commodity portfolios, and ongoing trades in the oil futures markets. The futures markets do in fact speculate on the price of oil; in fact, the futures markets help companies to reduce commodity price risks. The futures markets provide insurance against future price risks; unfortunately, the markets have been projecting increasing risks-the types of risks we read about in the newspaper every day. Perceptions of increased risks have driven oil prices in the futures markets higher; the markets by themselves don't drive anything-although they may overshoot temporarily in speculative fervor.

The major economic issue is that the short run demand for oil is relatively price inelastic: regardless of price, we can't alter our consumption very much in the short run. Furthermore, the futures markets price oil on the basis of risk; the markets have communicated concern about the security of the oil supply in recent months. However, in the long run we can make major changes-by buying smaller cars, moving closer to our jobs, changing our consumption and vacation habits, and adjusting to a world of higher prices through conservation. We have a short run problem (we can't really conserve much in the short run) and a longer run solution (Americans are resourceful--at prices over $100 per barrel we can be very creative over the time period of a few years).

From the viewpoint of supply, in the short term, the supply is inelastic. Regardless of price there isn't much more supply available. In the longer run, at the lofty prices we have been seeing supply can be somewhat more available. Oil has been going at a price in the neighborhood of $140 per barrel, up or down depending on week/month. However, the marginal cost of oil-the cost to obtain another barrel of oil-is estimated variously to be in the area of $80 to $90 per barrel-subject to the fact that it takes a few years to obtain that oil. There is a lot of recoverable oil at $90 a barrel and up, including recovery from previously uneconomic fields, new supplies, and deposits not previously considered economic.

Therefore, on a short run basis (a time period ranging between a few months and several years), opportunities to make major changes in supply and demand are limited. Under bad circumstances, the sky appears to be the limit for gas prices. If you throw in substantial concerns over political instability near the Straits of Hormuz, you can generate higher oil futures prices as well as a lot of generally meaningless postings to the blogs! However, in the longer run, supplies and demand are more elastic-a Petroleum Armageddon is not here. It is clear that gasoline will cost more and that higher efficiency vehicles and new end-use approaches are here to stay. Disaster, however, is not. In fact, in recent days much of the speculative fervor has cooled as people start to recognize reality. On a short run basis, the issue does not seem to be so much a shortage of oil as instability of markets due to inelastic demand. Longer run, substitution and market adjustments will resolve the issue-possibly with all of us still riding around in electric powered SUVs. We need to think in terms of short and long run supply and demand-the factors driving the markets and not really discussed in the press.

Interestingly, the volatility of oil prices seems also to have given Dr. Robert Shiller, of Case-Shiller housing price index fame, a problem. Dr. Shiller developed two paired Exchange Traded Funds: MacroShares Oil Up and Oil Down. The funds were paired, so their total value summed to $120. Oil Up tracked the price of oil on the upside, with Oil Down tracking oil prices on the downside. The two funds were tied together: when oil prices increased, assets moved on a dollar-for-dollar basis from Oil Down to Oil Up. However, neither fund owned any oil. The funds owned Treasury bills and captured the price movements of oil by proxy.

When the funds were launched, the benchmark oil price for NYMEXX light sweet crude oil was $60. Since the securities transferred assets on a dollar-for-dollar basis between funds based on changes in oil price, the limit to the OIL UP fund was designed to occur at a benchmark oil price equal to $120, at which Oil Down would have zero value. There was a provision for termination of the funds in the event that oil prices approached $120. The early termination event occurred on April 16, 2008, when the benchmark oil price closed at or above $111 for the third consecutive business day. The provisions for liquidation kicked in, with the funds being successfully closed on June 25, 2008. This highlights the potential risk associated with a derivatives contract: at some point one side of the transaction may reach zero. Someone can be wiped out and may, or may not, be able to pay; in this case there was no problem. Fluctuations in market prices can occur to the degree that a derivatives contract needs to be closed out. In this case there was success in closing the funds.

There are several lessons to be learned. First, oil prices price are driven by both supply and demand factors, and these can change over time. It is clear that energy conservation will be important, and that energy will continue to be expensive. However, we are not at the long term disaster point that the press likes to discuss. Second, in the short term the futures markets and general risk concerns can have a substantial impact on oil prices. Even as this is being written the oil markets are undergoing substantial change. Third, getting back to the basic concepts of supply and demand, there can be substantial price fluctuations in the short run; we can feel and have felt very uncomfortable at the pump! However, in the long run one would expect price to settle down at the replacement value of oil. Finally, a derivatives situation based on oil, or interest rates, or commodities can be used to reduce market risks but carries financial risks: it is possible for one side to be essentially wiped out if prices move adversely. Dr. Shiller recognized this potential when he designed the funds with a termination provision.

A consideration of supply and demand for oil suggests that the long run outlook calls for prudent conservation and an expectation that oil will not be cheap. However, it seems likely that the economy can adapt to whatever oil prices occur.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

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