Thursday, March 08, 2012

Gasoline Prices are a Policy Choice

The U.S. average price of gasoline has zoomed up 18 percent during the first two months of 2012. A rise that rapid is not caused by an increase in the demand for use. The increase is caused by speculators buying gasoline contracts. They expect higher prices because of possible oil disruptions in the Middle East, especially if there is a conflict with Iran.

Companies that use much gasoline have been able to hedge the prices of future purchases by buying futures contracts. Another way to hedge is with the U.S. Commodity Gasoline Fund, an exchange traded fund (ETF) with the trading name UGA. One buys shares of the fund just as one would buy shares of stock. If one expects the price of gasoline to fall, one can obtain a futures contract to sell gasoline, or else sell-short UGA.

The price of gasoline is a function of the price of oil, so one can go to the source of the price rise and buy shares of USO, the United States Oil Fund, also an ETF. Conversely or inversely, there are short ETFs such as DNO that have sell positions in energy contracts for those expecting a fall, or energy sellers that seek to hedge the current high price of oil to lock in the current prices.

Speculators can go long or short, long meaning owning contracts to buy, or equivalent ETFs, and short meaning contracts to sell, and short ETFs. Even if the rapid rise in oil prices is due to expectations rather than actual production costs and demand for current use, speculative prices can persist for many months. Hence even if one is confident that the prices will fall as fears ease, timing the market is an uncertain art.

The price of gasoline has become a big campaign issue. There are silly accusations that the recent restrictions on drilling in the Gulf of Mexico and delaying the construction of an oil pipeline from Canada have contributed to the oil price increase. The restriction of production and delivery are long-run issues unrelated to the current price rise. In fact, recent oil discoveries have resulting in substantial increases in US oil production.

What governments could do today to reduce the price of oil and gasoline would be to sell futures contracts in gasoline and oil. Most speculators who hold sell contracts do not have the actual commodity, and they sell the contracts before they expire for delivery. But the US government owns a huge pool of oil in its strategic reserve that would make US sales a hedging operation rather than a pure speculation.

Suppose the price of oil keeps rising despite U.S. government’s selling. If the price rises to $150 per barrel, the US government would be able to sell its reserve oil for $150 and liquidate its contracts, so it would be even. But if the price of oil falls, the US government would have a large profit from having shorted the market.

I’m not proposing or recommending that the US government sell oil futures contracts, just pointing out that if they wanted to, Congress and the President could bring down the price of oil and gasoline. Some critics have said that the federal government chiefs welcome a high price of gasoline in order to make “green” alternatives more profitable compared to fossil fuels. Whatever the motive, the high price of gasoline is a policy choice. There is no free market in oil, as the quantity of oil is manipulated by OPEC and influenced by government policies.

In the long run, demand for oil in the USA will fall as cheap natural gas replaces much of the oil consumption, and electric cars and fuel cells become more common. But for the present day, the high prices of oil and gasoline act as a tax to stifle the recovery. When folks spend more on gasoline, that leaves less money for other goods, and the reduction in demand results in less supply, less production, less employment.

If I were the president, I would sell futures contracts in gasoline. The price would swiftly fall, and the president would be a big hero. But this popularity could vanish as other issues become more prominent, so the most effective timing would be, say, two months before the November election. So don’t expect the government to act to reduce the price of gasoline any time soon.


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