What the Hell Is Up With Gas Prices?

As any of you who drive already know, gas prices are ludicrously high.  Driving across my state of North Carolina this weekend, I saw prices ranging from $3.75 a gallon up to $3.89.  In many places across the country, gas is already far beyond the $4.00 mark, something we haven't seen since 2008.  So, what exactly is causing prices to skyrocket and what can be done about it?

If you listen to the reports in the media, you usually get some combination of increased demand worldwide, especially China, or unrest in the Middle East.  These are not responsible for the increases you are seeing now.  If you follow politics you would believe that it is either a lack of production, especially domestic production (if you are a Republican) or vast greed upon the part of oil companies who are systematically driving up prices to fatten their dividends (if you are a Democrat).  Neither of these are the reason, either.

In my attempt to understand this predicament as well as the causes behind the world wide economic catastrophe that we have experienced over the last several years, I have concluded that there are three main causes for the current spike in oil prices.  One of these is mentioned in the media regularly, one occasionally, and one pretty much is never mentioned.

1.   Turmoil in the Middle East

The recent unrest in the Middle East, from Tunisia to Egypt to Libya is often cited as a main contributor to the rise in oil prices worldwide.  This is especially the case for those who look at the normal processes of supply and demand as a root cause for the increased price of oil.

There is no doubt that there are some systemic costs that are caused by the unrest in Libya and other oil producing countries which have had a slight contribution to the price of oil.  For instance, oil companies need to pay for additional security to insure that their ships are not attacked by one side or the other.  This probably contributes a dollar or two to the total price of oil, but is not responsible for the more than 100% rise in oil prices over the past several months.

A larger role played by turmoil in the Middle East is its psychological effect on the markets, especially futures markets as we will explore in more detail under number 2.  As stability decreases in the oil producing regions, there is an obvious unease among investors in oil and other commodities as the fear of the unknown would lead many to expect the worst.  This undoubtedly contributes to the rise in prices.

However, the most often referenced reason that the unrest in the Middle East has contributed to increased oil prices is that of supply and demand.  It is argued that along with the increased demand by emerging economies, especially China, the ongoing political turmoil has led to a decrease in supply.  This is simply rubbish.  I have been unable to find one singular instance of any decrease in supply coming from the Middle East or anywhere else.  There have been no disruptions in the supply network, not a single tanker bombed or captured, not a single oil field torched.

So why is it that this is the most often cited reason for the increase in prices?  The only reason I can fathom for this is that it is the long entrenched belief by economists and market analysts that our markets are rational and therefore they look for a rational explanation for the increase in prices.  But even a cursory look at the actual supply and demand worldwide would prove this assumption incorrect in this case.  Even with the increased demand in China and other emerging economies, the worldwide demand for oil is stable, if not falling.  That combined with the fact we have already discussed that supply is also stable would lead one to believe that costs of oil should be stable or decreasing.  Perhaps a slight increase due to increased expense would be believable.  But rational factors are not the cause of this spike, so there must be other reasons for prices to be quickly approaching their all time high of $149 a barrel in late Summer 2008.

2.    Speculation

In 2008 when oil prices reached their all-time high of $149 a barrel and gas prices were more than $4.50 a gallon all across the U.S., there was eventually much talk about the role that speculators played in the process.  While many investment houses like Goldman-Sachs and JP Morgan were downplaying the role that speculators were playing in the oil bubble that was becoming an economic monster, later studies of the commodities market confirmed that speculation in oil futures was the largest contributor to the sharp spike in prices that were seen in the second half of 2008.

It is necessary to understand the role of a speculator in commodities markets and how this role has changed over recent years in order to understand the effect these players had and continue to have in the oil market (as well as other commodities).  Commodities markets provide a platform in which producers and buyers of raw goods that are essential for consumers can buy and sell their goods.  Farmers, for instance, sell their grain on the commodities markets and say makers of cereal buy the grain from the farmers in the same market.  Speculators traditionally provide an important, albeit limited role in the commodities exchanges.  Essentially speculators provide fluidity to the markets by contracting to purchase or sell goods at a certain price in the future.  This guarantees that even if there are no buyers or sellers that there will still be a market because the farmer will be able to sell to the speculator even if it is at a reduced price if the cereal company is not buying when he is selling.

As long as everyone kept to their role, everything was peachy-keen.  So, you ask, how did speculators end up skyrocketing the price of oil (along with lots of other commodities to boot)?

Well, speculators have been allowed to expand their participation in the commodities markets with disastrous effects.  During the first Bush administration several investment banks applied to the Commodities and Futures Trade Commission for an exemption which would allow them to trade on commodities exchanges as if they were themselves producers and purchasers of the commodities.  The CFTC bought their argument, and issued 16 letters to large speculators owned by investment banks granting them this exception.  The problem with this is that unlike producers and purchasers of the commodities themselves, speculators do not have a vested interest in the market for these goods, their only interest is to make as much money off of the deals that they can.

This exemption was amplified at the very end of Clinton's presidency with the passage of both the Gramm-Leach-Bliley Act and more so the Commodity Futures Modernization Act.  Gramm-Leach-Bliley was passed in 1999 by a Republican Congress, but with the overwhelming encouragement of Bill Clinton's financial team, most encouraging among them Robert Rubin (this act was referred to by some as the Citigroup Authorization Act since Citigroup could not exist without its passage; Rubin would go on to become one of the highest executives at Citigroup reaping tens of millions of dollars in compensation).  Gramm-Leach-Bliley did away with the depression era Glass-Steagall Act which mandated the separation of commercial banks and investment banks.

More important to this discussion is the passage of the Commodity Futures Modernization Act, which insured that all derivative trading would be free from any government regulation.  This led directly to every economic disaster that we have seen since, most notably the collapse of Enron (both bills were spearheaded by Sen. Phil Gramm, whose wife Wendy Gramm was head of the CFTC under the first President Bush and was a board member of Enron who benefitted most immediately from the provisions of the act), the real estate bubble of the late 2000s and the ensuing collapse of the credit markets when the real estate bubble burst leading to the bailout of the entire investment banking sector.

In addition to all of these monumental economic disasters caused by the Commodity Futures Modernization Act, it also led to the enormous increase in oil prices in 2008.  This is because banks such as Goldman-Sachs and JP Morgan, newly emboldened by the complete deregulation of derivative investments combined with their newly expanded role in the commodities market, developed new derivative investments called commodities index funds.  What these derivative investments did was allow investors to invest their money in broad ranges of commodities, sort of the same way that a mutual fund or a 401(k) invests in a broad range of stocks and bonds. 

The problem with this is that an investor in this type of fund is going to be in it for the long haul.  Because of this, their only position is "long" -- that is, they are betting that the price of these commodities will go up.  And up they did.  With this amount of money being invested into the commodities markets, the only place for prices to go was up.  Matt Taibbi in his book Griftopia gives an example of a person going to a car dealership and saying "Give me $500,000 worth of cars."  Since the person doesn't care about the kind of car or the amount of cars, just the price, eventually someone is going to sell him a $500,000 car, and the average car buyer is going to be priced out of the market.  The same thing happened with oil.  With this many people betting on the cost of oil to go up, and the vast amounts of money that were fueling this bet, the skyrocketing of oil prices became a self-fulfilling prophecy.

Eventually, the bubble burst and prices returned to their pre-bubble levels.  So, what has been done since this debacle to prevent this from happening again?  Absolutely nothing.  Since Congress balked at any serious reform in the Dodd-Frank bill passed late last year, and did nothing to return the role of speculators to their previous limited status on commodities exchanges, or to regulate derivatives into open, transparent exchanges, or to re-establish the necessary separation of commercial and investment banks done away with in 1999, the exact same thing is happening again.

Investment banks are still shilling these disastrous financial products to their customers, "long only" speculators are still driving up the price of commodities to unsustainable and non-realistic levels and we are paying for it at the gas pump. 

But this time it will be even worse.

3.   The Weak Dollar and Inflation

Last week, Ben Bernanke held a press conference and stated (with a straight face, mind you) that he was leaving the Fed's prime interest rate at 0% because he felt that there had not been significant increases in inflation to warrant an increase in the lending rate and that the dollar was strong and stable.  Anyone who has put gas into their car or shopped at a grocery store over the past few months would have to greet such a statement with disbelief.  It almost seemed that Bernanke was living in an alternate world.

Well, in a way he was.

The United States judges inflation by the use of the Consumer Price Index (CPI) which is essentially an economic snapshot of prices throughout the economy at any particular time.  The CPI, however, due to the findings of the Boskin commission in 1995, doesn't really look at everything.  The Boskin commission studied the CPI and through some rather questionable mathematical tricks, decided that inflation had been overestimated by 1.1% over the years.  To do this, they implemented among other things "hedonic adjustments" which said that things aren't really more expensive, they are just better and the increased quality of the product cancels out any increase in price; and "substitution adjustments" which said that as prices for products such as say steak increase, consumers substitute less expensive chicken and therefore pay the same price -- the economic equivalent of "let them eat cake."  So, in effect, inflation as reported is less than inflation actually.

But, the Fed actually has an even smaller view of what inflation is.  The Fed in order to judge inflation uses the Core CPI, which I guess they believe is a more accurate view of inflation to consumers.  How, I don't know.  The Core CPI excludes energy costs and food.  Huh?  Yup, that's right, the Fed bases their decisions about the economy on a view of inflation that excludes the two highest expenditures for most consumers.

During the 2008 oil bubble, the U.S. dollar was weak.  This was mostly because of the policies of the Federal Reserve.  In order to spur growth and encourage investment, the Fed initially under Alan Greenspan and subsequently under Ben Bernanke embarked on an economic Kamikaze mission to continually cut interest rates.  This was for the most part loved by Wall Street since it meant they could borrow money very cheaply and then invest it in increasingly risky exotic derivatives and make boatloads of money.  However, the other effect that the race to the bottom on interest rates was that the market was flooded with dollars, and the dollar was weakened substantially.

In 2008 the prime Fed interest rate started out at 3.00%.  It was lowered throughout the year, and during the height of the oil bubble, the interest rate was about 2.25%.  After the collapse of Wall Street investment banks that year, it was lowered again to 2.00% in October and by the end of the year had gone to 0.0% where it has remained ever since.  This is unprecedented in the history of the Federal Reserve.  It is also reckless. 

By the time interest rates were taken down to their current levels at the end of 2008, the oil bubble had long since burst and levels had gone back to their pre-bubble levels.  However, there is no doubt that the weak dollar contributed to the increase in gas prices.  Since the dollar is still accepted as the world's most common reserve currency, oil is traded world wide in U.S. Dollars.  As the U.S. dollar is weakened, the price of oil inevitably increases, as a dollar simply cannot buy as much oil as it had in its former stronger levels.

With interest rates staying at 0% for 2 1/2 years with Bernanke saying there is no plan to adjust the Fed rate upward any time soon, the dollar is far weaker than it was in 2008.  When you add to the low interest rates the fact that the Fed has pumped trillions of dollars into the economy in the form of bailouts for failed financial institutions, the dollar is even weaker.  The effect this is going to have on price levels being spurred on by speculators is going to be one of magnification.  The price of oil is likely to be higher than its previous high of $149.  Furthermore, even when the new speculative bubble that we are now seeing bursts, the chances that prices will return to their post-2008 bubble levels is unlikely.

In essence, this means that I would not be surprised if gas reaches in excess of $5.00 per gallon, possibly even eclipsing the $6.00 a gallon level by the end of the Summer.  Furthermore, after the bubble bursts (which it inevitably will), we will probably not see gasoline for under $3.00 a gallon for a very long time.  This of course will increase costs for food, milk, and other necessities as well, and yes, people around the world will starve.  But don't worry, Ben Bernanke says these things don't really matter, so stop whining.