With gas prices having risen forty cents in the United States on average since last February, some are blaming President Obama. Most Americans understand that the price of gasoline domestcially rises and falls in approximate correlation with the price of crude oil, which of course is needed to make the gasoline. However, there is an erroneous tendency to reflexively assign blame or credit to the president for the state of gas prices. This is not to say that such claims never have any merit, but the reality is far more complicated. In order to assess whether this would be fair, it is first necessary to explore the factors that enter into determining the price of a barrel of oil.
First and foremost, like stocks, the price of oil is determined on exchanges by the actions of buyers and sellers all over the world. On these exchanges, various “brands” of crude are traded, pumped from different parts of the globe. Because the degree of refinement needed for these different types of crude varies (depending on the level of impurities they contain), and because each oil-exporting country is geopolitically unique, some price divergence is inevitable. On the whole, however, when the price of one brand rises or falls, chances are the others do likewise. This is because oil price is largely driven by prevailing global macroeconomic conditions, or more precisely, the perception of prevailing global macroeconomic conditions.
But the price of oil can also be influenced by something else — the strength or weakness of the U.S. dollar. This is because the aforementioned global brands of oil are priced in the American currency, which means that all other things being equal, there is an inverse correlation between the price of oil and dollar strength. If investors are bearish on the U.S. dollar, they will offload at least some of their greenbacks and take on other assets such as stocks, precious metals, and commodities (such as oil), thereby sending their prices higher. In addition, they will seek to short the dollar versus other currencies whose value they think will appreciate. Hence, in the wake of both rounds of the Federal Reserve’s inflationary quantitative easing, asset prices rose while the value of the dollar fell.
Interestingly, the better the global economy gets (or is perceived to be getting), the higher the price of oil is likely to go, and often without much regard for the ratio of actual supply to demand. Each week, the governments of major economies release important economic data concerning unemployment, retail sales, home sales, purchasing managers’ indexes, and other information. Releases that show marked improvement can send the price of oil higher, especially if the data is seen as part of a wider bullish trend. By the same token, rising oil prices may inhibit economic growth because increased energy costs can discourage production and consumption alike.
The truth is that on a given day, it often isn’t clear why oil prices rise or fall. Did oil spike because of escalating tensions vis-à-vis Iran and the fear of a possible disruption in the supply of oil from the Middle East? Or was it because unemployment in the world’s largest economy decreased more than expected? Or maybe oil rose not because of macroeconomic factors, but because of technical considerations and was caused by the previous day’s close above $100. (Of course, explaining oil price action as a result of technical analysis is a whole other matter.)
Whether you’d like to blame the president for high gas prices or not, it is crucial to understand these ingredients of oil’s price discovery process. In the next article, we'll look more closely at Obama's policies and determine to what extent they have contributed to higher gas prices, if any.
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