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Friday, May 6, 2011

Don’t Hate The Player, Hate The Game: A Clarification on Who to Blame in Periods of Rising Gas Prices

After watching such a liberating trading day in Oil yesterday, I woke up excited.  Excited to drive by the gas stations on the way to work and see the dramatic decrease at the pump.  Needless to say, it wasn’t a great morning.  Nearly every station was still selling regular unleaded at a whopping $4 a gallon.  I was very upset.  I wanted to blame someone for the hypocrisy of gas prices!  When Crude Oil goes up 10% I can assure you it will be represented the next day at the pump, but if Crude goes down 10% we are lucky to see any sort of material reduction. 

Well I gathered some data this afternoon, ready to crunch some numbers and right a blog shunning the oil companies for their actions.  After finishing my spreadsheet I was wowed by my results.  Keep in mind this isn’t the most advanced spreadsheet.  It doesn’t take into account the value of the dollar which has a significant impact on the price of crude.  With that being said, the spreadsheet has enough sophistication to provide results.  So what did I learn?

Point 1: I ran a correlation calculation on the average monthly price of crude from 2004 to present against my calculated profit margin per gallon of gas.  The result was -.4.  So that means that there is a negative correlation between the two.  Translation: Every time the price of crude increases, the profit margin per gallon decreases.  You could say that in most cases when the raw material of a good dramatically increases then the profit margin will decrease, but we are all well aware that the price of gas moves along with the price of crude.  So you would think a consistent profit margin would be maintained.  Not the case.

Point 2: The highest profit margins per gallon were achieved when crude was trading at about $55 a barrel.
 
Price Per Barrel
Total
Price at the Pump
profit margin
$55.43
$1.97
3.14
37%
42.45
$1.66
2.61
36%
$59.25
$2.06
3.05
32%
$56.08
$1.99
2.84
30%
$58.56
$2.04
2.9
30%
$55.12
$1.96
2.717
28%


Point 3: This is self explanatory given the previous two points, but negative margins were achieved during the periods in which crude was trading at very high prices.

$96.87
$2.96
3.24
9%
$125.00
$3.63
3.76
4%
$140.00
$3.98
4.05
2%
$145.00
$4.10
4.06
-1%
$84.47
$2.66
2.09
-27%


(These calculations are based on the assumptions that there are 42 gallons of gasoline in each barrel of crude and a tax of .65 cents is subtracted from each price at the pump)

What does this mean for us?

Well this means that Oil companies are still not sure what to charge at the pump.  There is no consistency in pricing at a certain level of crude prices.  You would think that by now a price of x dollars per barrel will always charge y dollars at the pump.  This is not the case.

Pretty much Oil companies are at the mercy of the market.  They deal with the egregious nature in which the speculators operate.  The oil companies are not the people to blame for the constant never ending erosion of every American’s discretionary income.  Here is the problem, the speculators have no interest in seeing a stability in crude prices.  There job is to buy and sell crude based on information that never seems to be true!  Which makes sense because they will spread rumors like “Crude supply levels next year will be 20% below expected.”   A statement like this will cause turmoil in the markets with everyone hedging their investments based on information that isn’t always correct.  Excuse me SEC, but how is this not manipulating the market?  Not only do speculators invent information to trade on, but they use current events like turmoil in the Middle East to drive up the price of crude.  For a while, every time Gadaffi let out a fart crude went up 5 points.  This is no way trading should take place, there is to much at stake.  I don’t think that we should regulate the commodity markets, but I do think we should set certain trading restrictions on people that trade crude on a daily basis.  These people need to fully understand the impact of their profit gauging behavior and the incredibly uncomfortable position they put the free market system in.

The problem in the short term, of course, is the irresponsible nature in which crude is traded.  Regulation on how these traders act, would not impede on the free market system.  All I’m saying is there needs to be one unbiased reporting source of commodity information.  Level the playing field for once.  Let there be some transparency on the real supply of crude in the world, and when it’s forecasted to run out.  Then let the price fall where it may, but right now having crude spike every three years isn’t working for anyone.  Also limit ETF’s for crude, if you want to buy crude you better clear some closet space and buy a barrel.  Auction off the day’s barrels to people who intend on keeping the product.  I don’t go to the grocery store and buy a bag of chips, tell the world that the supply of potatoes is down 50%, and then sell the chips at a 30% profit.  That would be wrong….and time consuming.

In the long term we need to put through legislation for alternative energy.  I don’t care if we use ethanol, solar, wind, hydro, or frying oil.  The important part is we diversify our energy portfolio.  Viable alternative options on energy reform will reduce the volatility of crude oil.  In fifteen years, if half of all vehicles run on something different then gas the price of crude oil will decrease.  The reason for this is that the estimated longevity of supply will essentially double because of the diversification.  If we are pricing based on supply and demand, then that will not only reduce the volatility of gas prices but it will reduce them as well.

I believe in the free market.  It’s the backbone of capitalism.  Without the free market, businesses wouldn’t be able to finance growth and individuals wouldn’t be able to grow their retirement savings.  Greed is a facilitating force in the free market as well, but there is a distinction.  It’s one thing for greed to rule your life, but when your greed adversely affects everyone except for yourself then there’s a problem.  There are few transactions in the free market that achieve such a result, and oil speculation is one of them.   So in conclusion, don’t hate the Exxon’s and Chevron’s in the world.  They’re not perfect, but they aren’t the worst people out there.  As mentioned previously, the speculators are the problem and all we can do is hope that in Washington they get smart and start regulated their actions.

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