Term Paper on "Rising Gas Prices Anyone Who Has Filled"

Term Paper 11 pages (3833 words) Sources: 6

[EXCERPT] . . . .

Rising Gas Prices

Anyone who has filled up their gas tank lately knows that prices have been on the rise for some time. Fluctuations in gasoline at the pump are a reflection of fluctuations in the price of the raw material from which it is made, crude oil (Federal Reserve, 2004). When oil prices peak the public, sparked by the nightly news, tend to overreact. They fantasize about what the world will be like when everyone stays home because they cannot afford gasoline to go places. The picture that some paint is that of economic ruin and despair. However, in reality, the effect of gasoline is not as dramatic as many would believe. The following will examine the real effects of gasoline price fluctuations on the economy.

The first concept that one needs to understand when it comes to gasoline prices is that the nominal price might go up dramatically, but when one adjusts the price for inflation, the price increase appears to be much smaller (Federal Reserve, 2004). There is historic precedence for panic when oil prices soar. In the 1970s and 1980s oil prices did have a dramatic impact on the country. However, there were many factors that were different then, and it is not as likely that the recent price rise will have the dramatic effect that it did back then (Federal Reserve, 2004).

Oil prices are like any other commodity market. They go up and they go down. The real question that one must ask about the most recent oil price rise is whether this is just a temporary spike that will eventually correct itself, or whether it indicates a long-term trend (Federal Reserve, 2004). Ther4e are several indicators that can be useful in making this determination. One of these instruments is to watch options and futures trading.

The Financial Markets and Oil

Predicting the financial markets is not an exact science and no one knows for certain what the future will hold. However, for many, the markets are a high stakes game and there are many skilled players. Contracts for oil futures are traded continuously on an active market. Traders of these commodities know their product inside and out. They are an excellent source for an experienced opinion as to where prices are likely to go in the future (Federal Reserve, 2004). Options markets are also a good source of information as well. These instruments can be a good indicator of the degree of uncertainty that traders feel regarding a certain commodity.

Generally speaking, certainty and stability is good for the economy. Uncertainty and volatility is bad for the economy (Federal Reserve, 2004). Uncertainty tends to make companies cautious when making capital investments (Federal Reserve, 2004). Investors are willing to take their chances on a short-term period of uncertainty. The amount of risk that they are willing to endure depends on the length of time that they expect the uncertainty to last.

Oil futures are especially important for the economy. Oil is a basic need and can be a driving factor in other commodities (Kilian, 2007). Oil effects heating, energy and transportation costs. When oil prices rise, it has a trickle down effect on other commodities. Oil prices affect other products in two primary ways. Oil is a necessary resource for many other products. For products, such as cosmetics that use petroleum products as raw materials the effect of rising oil prices is direct. There is only so much expenditure that can be absorbed before prices must be raised to maintain profit.

For other products oil has a secondary effect. Almost every commodity that is produced must be transported. Transportation requires oil products, such as gasoline and motor oil. Oil is a direct cost for the transportation industry. However, as the price for oil rises and begins to affect the cost of transportation, these costs must be passed on to the end consumer. Therefore, oil also has an indirect effect on other products. For some products, oil has both a direct and an indirect effect. If the product uses oil its manufacture and then the final product must be transported, the effects of oil prices has a double affect.

It is easy to see how rising oil prices could have the potential to wreak havoc on other sectors of the economy from small electronics to the price of agricultural products. The amount of direct effect and indirect effect differs from segment to segment and from product to product. The effect of rising oil prices is not homogeneous across the economy. Other industries must struggle to make up for narrowing margins as oil prices rise. The problem is not oil prices themselves, but the additive effect that they have on other products. This is the key reason why uncertainty in oil future causes uncertainty in many other parts of the economy as well.

Since 2004 when oil prices began to rise, oil futures demonstrated uncertainty. The problem is not that they rose, but that they are expected to remain high for quite some time (Federal Reserve, 2004). In retrospect, these oil investors were correct and oil prices rose to levels that were not even imagined. No one can predict the future, but the beliefs of the investors plays an important role in the mount of uncertainty that is reflected in the economy. In 2004 investors expected prices to decline from their current levels, but to still maintain a higher level than they were prior to the rise (Federal Reserve, 2004). It is not what oil prices actually do that is the key factor in economic uncertainty, but the expectations of what they will do that is important from the perspective of the financial markets (Kilian, 2007).

Supply and Demand

Generally, prices are a reflection of the balance between oil supply and oil demand. Basic economic principle states that when supply is high, prices are relatively low. Conversely, when the demand outpaces the supply, prices rise. The recent rise in oil prices would theoretically reflect a state where high and rising prices reflect rising demand. According to the International Energy Agency (IEA), global consumption is expected to continue to rise sharply in the near future (Federal Reserve, 2004). Oil consumption in Asia and Chins still lags behind that of the United States, but Asia cannot be discounted as a source of rising demand. As Asia, particularly China, become more industrialized oil demand continues to rise. Emerging markets, such as these, are now major contributors to crude oil demand on a global basis (Federal Reserve, 2004). The individual countries might not represent that much of an increase individually, but collectively their impact is substantial.

The demand side of the equation spins out of control on its own. However, the same cannot be said for the supply side of the equation. On the supply side, oil production has been limited by several factors. The first is geography. Exploratory drilling is expensive and might not always result in a significant find. Oil is only available and accessible in a limited number of locations. Geopolitical issues also limit production in several areas. Oil prices can be controlled somewhat be limiting production at drilling and crude oil processing facilities (Federal Reserve, 2004. Supply can be controlled somewhat by production agreements with the Organization of Petroleum Exporting Countries (OPEC). When supply is low compared to demand, OPEC can decide to pump more oil to make certain that the demand is met (Kaufman, et al., 2007).

Controlling the supply can also be used as a price control mechanism. For instance, OPEC might cut production in order to lower the supply available to meet demand. This would cause an artificial price adjustment and rise in oil price, even though there is no need for it. This is often looked down upon by a majority of the world. However, OPEC is one of the largest oil producing conglomerates in the world. There are other countries that have a small domestic supply, but they cannot meet the demand as easily as the Middle East (Kaufman, et al., 2000). Until a replacement supply can be found that adequately can replace that which is supplied by OPEC, the world will be subject to these artificial price fluctuations.

Source: Williams (2005).

The only reason that OPEC can get away with controlling supply to manipulate price is that oil is such a basic commodity that no one can live without it. There are several substitute products that are still in the experimental stage, such as methane, biofuels, and other replacement fuels. However, at the current time, these are not being produced in a quantity that is sufficient to replace the needed oil altogether. Therefore, the world is still highly dependent upon oil and it appears that it will be for quite some time. With substitute products far down the horizon, the world will continue to depend on oil for a long time into the future.

Aside from limits on capacity as a contributing factor to volatility in oil prices,… READ MORE

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