Why We Should Care About Petroleum Prices and the Federal Reserve

What is pushing up oil and gasoline prices? How should the Federal Reserve (Fed) react to these prices? Both of these questions are important to all of us. Higher gasoline prices have definitely been hitting our wallets and the future actions of the Fed could impact the interest rates that we pay for the balance on our credit cards. I will attempt to provide some clarity on both of these issues.

Let me begin by explaining my interest in oil and gasoline prices. In the spring of 2004, I was an undergraduate in an Intermediate Macroeconomics course that started my journey on trying to better understand these prices. At the time, the price of regular grade gasoline topped $2.00 per gallon for the first time and the price of crude oil futures (contract to purchase a barrel of oil for delivery one-month in the future) was hovering around $40 per barrel, both of which seem like a sweet dream for consumers today.

After some success with a simple model, I put my interest to work in graduate school by publishing a paper with Dr. Ronald D. Gilbert that introduces a forecasting model that explains the relationship between gasoline prices and the price of crude oil futures. We first studied what the Energy Information Administration (EIA) notes as the components that make up the price of a gallon of gasoline. These components are crude oil, distribution and marketing, refining costs and profits, and taxes (includes federal and state taxes). Our research confirmed that crude oil was the primary component that would significantly affect gasoline prices; crude oil made up 68% of the price of a gallon gas in 2010 and all of the other components over time have remained roughly the same or fallen.

Our conclusion was that a 10% increase in the price of crude oil futures in the current week will lead to a 2% increase in the price of regular grade gasoline. We were aware that while our model predicts well on average over our sample period, predicting future gasoline prices may be difficult at times due to exogenous shocks, which are unexpected events that affect gas prices besides oil price futures (i.e. hurricanes). Recently, there have been a number of these exogenous shocks that have driven oil and gas prices to levels that have brought them once again to the forefront of consumers’ budgets.

In 2008, Professor Kilian, an energy economist, wrote a blog post about why gasoline costed so much. His basic story was that the increase in gasoline prices was from a combination of supply, demand, and what he called “precautionary demand” (purchase of oil in the present based on oil supply concerns in the future). Specifically, his argument was that the increase in gas prices in 2008 was from higher world demand for oil from China and India that pushed up gasoline prices as well. Similar events are also apparent this time around that include: The expansion of the global economy that has increased demand for oil; the lack of ability for oil supply to keep up with the pace of demand; and, more importantly, the political turmoil in the Middle East and North Africa (precautionary demand). 

The EIA highlights that “over one-third of the world’s liquid fuels are produced in the Middle East and North Africa.” The EIA also reports that the price of crude oil futures, which is priced in dollars in the world market on the New York Mercantile Exchange (NYMEX), started off 2011 at $91.55 per barrel and since then it is up 15% to close at $105.40 on March 25, 2011. The weekly average of regular grade gasoline prices have increased by 17% from the beginning of this year to $3.60, as of the prior week to March 28, 2011. According to our model discussed above, the price at the pump should be closer to $3.10. The difference of $.50 is substantial, but other events, such as Hurricane Katrina, also pushed this difference to similar levels.

What does this difference mean? The relationship found in our model is based on gas and oil prices only; therefore, it is not capable of including the events in the Middle East and North Africa. We do know that gasoline prices over time revert back to the relationship where a 10% increase in the price of oil futures leads to a 2% increase in the price we pay at the pump. Considering this substantial difference, what may this indicate about oil price futures and gas prices?

The signal here is that retail gasoline prices far exceed their normal relationship to oil price futures and could fall drastically if the political unrest stabilized. Another explanation could be that gas prices are priced correctly in the market and oil price futures have further to rise to achieve their statistical relationship. Or, it may be that there has been a structural change in the relationship between the two variables and the model is now flawed, which is why I am analyzing a number of other variables that may more efficiently predict gas prices in the first chapter of my dissertation.

We must keep in mind that oil prices were up to $145 per barrel in July 2008 before the prices collapsed to $35 per barrel in January 2009 as the Great Recession slowed demand for oil. Although the recent rise in oil and gas prices have been driven primarily by precautionary demand, it is likely that when the political unrest in the Middle East subsides there will be a drop in oil and gas prices. These are the foundations for the Fed’s reasoning to not worry about these prices, which were expressed by the former Federal Reserve Governor Lawrence Meyer.

The question is whether the increase in oil and gas prices has also been created by the actions taken by the Federal Reserve through their quantitative easing measures, where the Fed has purchased long-term government securities to put downward pressure on interest rates. As I noted in a previous article, there are other reasons the Fed should increase the federal funds rate other than the lack of elevated inflation (currently the headline consumer price index is 2.1%). In addition, the increase in oil and gas prices have lasted for quite some time and may eventually pass through to many of the other goods and services that we purchase. The Fed’s actions take time to go into effect; therefore, these issues further the case for higher interest rates and an end to these quantitative easing programs sooner rather than later.

While the proposed action by the Fed would raise rates that banks lend each other overnight and therefore push up the interest rates we pay on our credit cards, it would allow for oil and gas prices to stabilize by putting upward pressure on the value of the dollar relative to other currencies and incentivize firms to put their cash to use from the anticipation of higher borrowing costs in the future. Understanding how oil prices, gas prices, and actions taken by the Fed affect our decisions everyday is important. Finding ways to improve our livelihood from better understanding these variables is what I find to be a necessity!

Photo Credit: Wikimedia Commons