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Inside the Vault - Fall 2007

Inside the Vault - Fall 2007

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Published by: Federal Reserve Bank of St. Louis on Aug 12, 2010
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An Economic Eucaion Newlee om he Feeal reeve Bank o s. Loui
Why Do Gasoline Prices React to ThingsThat Have Not Happened?
Volume 12, Iue 2 Fall 07
ave you ever wondered why gasoline stations raise theirprices in response to fears about future supplies of oil? Youmay have thought to yourself, “I know the gasoline in the station’sunderground storage tank was purchased before the world priceincreased. How can they raise the gas price now? The gasolinemarket must be rigged.”In fact, gasoline stations should raise their prices to reflectincreased future costs of replacing their inventories. Prices act likeengine or voltage regulators—they automatically speed up or slowdown the flow of the commodity in order to maximize performance,or what economists call allocative efficiency. (Consumers get thegoods for which they are willing and able to pay.)
Oil and Gas, Here and There, Then and Now
 To understand why U.S. gas prices respond now to things thatmight happen in the future, halfway around the world, one mustunderstand how spot and futures prices for storable commodities,such as oil or gasoline, are related to each other.The cost of oil comprises about half the cost of gasoline, but oilis the most volatile component; other factors, such as taxes andprofit margins, do not change often.The figure above shows that while gasoline prices can divergefrom oil prices for short periods because of seasonal demand, taxchanges or other reasons, the two prices are closely linked overlonger periods.Because oil can be transported anywhere, trading on global spotand futures markets determines the global price of a given grade of oil, aside from local taxes and transportation costs. Oil can eitherbe sold for immediate delivery or stored for sale in the future;so, firms adjust their inventories in response to news about thefuture supply and/or demand for oil.Because oil is such an important component of gasoline,wholesale gasoline prices react instantly to changes in oil prices,including those caused by expectations of future events. Theprice at your local gas station will change nearly as quickly as thewholesale price.Let’s see how two hypothetical competing gasoline stations in asmall town might react to a sudden increase in the price of oil. Onone quiet morning, both the Conch Gas station and the PegasusGas station were charging $1.999 per gallon of regular gasoline.They each had bought their inventories a few days before at a costof $1.48 per gallon. With federal, state and local taxes combiningfor 50 cents per gallon, each station calculated that it would makeabout 2 cents per gallon at a retail price of $1.999.During the late morning, news of an unsuccessful terroristattack on Saudi Arabian oil fields spurred widespread fears of cuts in future oil supplies. As frenzied trading on exchangesin New York, London and elsewhere bid up the world price of oil, the station owners learned that wholesale gasoline prices fordelivery next week had increased by $1 per gallon. Both ownersraised their prices to $2.99 per gallon.Despite much grumbling at the price increases, sales at theConch Gas and the Pegasus Gas stations proceeded much asbefore—both stations sold out their existing inventories right onschedule and then took delivery on a new load of gasoline at thenew, higher wholesale prices. The station owners made a tidy,unexpected profit that week—$1.02 per gallon.
Are the Gas Stations Gouging Us?
Did the stations’ simultaneous price changes the week beforewholesale prices actually went up prove that Conch Gas andPegasus Gas were colluding to gouge consumers? No. Thesecompeting station owners did not have much choice if theywanted to remain as profitable as their competitors and stay inbusiness over the long haul.Suppose first that only Conch Gas had held its price at $1.999,while Pegasus Gas had raised its price to $2.999. Conch Gasobviously would have captured all of the traffic that day, but itsstorage tank would have run dry much sooner than expected.By the first or second day after the overseas disruption in the
continued on back cover 
       C     e     n       t     s       /       G     a        l        l     o     n        $       /       B     a     r     r     e        l
1988 1991 1994 1997 2000 2003 2006
Domestic Spot Market Crude Price: West Texas Intermediate, CushingAverage U.S. Conventional Gasoline Regular Spot Price
SOURCES: Crude oil prices are from
The Wall Street Journal
.Gasoline prices are from the U.S. Department of Energy.
Oil and Gasoline Prices Move Together
What is a commodity?
A commodity is a food, metal orother fixed physical substance that inves-tors buy or sell, usually through futurescontracts. Agricultural products, metals,petroleum, foreign currencies, and finan-cial instruments such as Treasury billsand bonds are commodities. Petroleum(crude oil) is the world’s most activelytraded commodity.
What are spot and futures markets?
 A spot market is one in whichcommodities are traded for near-termdelivery—within a month for oil markets. A futures market is one in which a com-modity is traded for delivery on a speci-fied future date, which could be monthsor years away. Major fuel users, such asairlines and trucking companies, oftenbuy oil in futures markets to guaranteethe cost of the fuel they will use.
What are the benchmark crude oils?
Grades of crude oil are determinedby their specific gravity and sulphurcontent. There are so many differentvarieties and grades of crude oil that buy-ers and sellers refer to a limited number,which are called reference or benchmarkcrude oils. Other varieties are thenpriced at a discount or premium relativeto the benchmark. Brent blend crude oilpumped from the North Sea is generallyaccepted to be the world benchmark. According to the International Petro-leum Exchange, Brent is used to pricetwo-thirds of the world’s internationallytraded crude oil supplies. In the PersianGulf, Dubai crude is used as a bench-mark to price sales of other regional
What is the difference between nominal andreal prices?
Nominal ice, omeime calle cuen olla ice,meaue he olla value o a ouc a he ime i waouce. real ice ae ajue o geneal ice levelchange ove ime, i.e., infaion o efaion. thee aju-men give u a icue o ice o vaiou yea a i hevalue o he olla wee conan.
Were nominal prices for oil higher in 2006 thanin any other time during the period 1973-2006?
Ye. the blue line on he gah inicae ha he icee bael in cuen olla, i.e., he nominal ice, waaoximaely $60 e bael in 2006.
Were real prices for oil higher in 2006 than inany other time during the period 1973-2006?
No. the gey line on he gah inicae ha he eal ice,i.e., he ice ajue o infaion, wa highe in 1981, amoe han $39 olla e bael.
Second Quarter 2007
(pecen change a an annual ae fom he eceding eiod.) 
Q3-’06 Q4-’06 Q1-’07 Q2-’07Growth rate —Real Gross Domestic Product 1.1% 2.1% 0.6% 4.0%*Infation rate —Consumer Price Index 3.1% –2.1% 3.8% 6.0%Civilian Unemployment Rate 4.7% 4.5% 4.5% 4.5%
*peliminay eimae 
Economic Snapshot
crude oils to Asia. In the United States,the benchmark is West Texas Intermedi-ate (WTI). This means that crude oilimports into the United States are usuallypriced in relation to WTI. The Organiza-tion of Petroleum Exporting Countries(OPEC), a cartel of some of the world’sleading producers, has its own reference,known as the OPEC basket, which is anaverage of seven crude oils. Six of thecrude oils included in the OPEC basketare pumped by member countries, andthe seventh is from Mexico. In practice,however, price differences are not large.
The Q&A segment was largely adapted from: theFAQ on Chicago Board of Trade web site, www.cbot.com/cbot/pub/page/0,3181,1065,00.html, andBBC News online, Oil Markets Explained, http:// news.bbc.co.uk/2/hi/business/904748.stm.
1973 1976 1979 1982 1985 1989 1991 1994 1997 2000 2003 2006
   $   /   B   A   R   R   E   L
Refiner Acquisition Price of Crude Oil, 1982-’84 dollars
Refiner Acquisition Price of Crude Oil in That Year’s Dollars
Nominal vs. Real Oil Prices
sOUrCE: the Fedeal reeve Bank of s. Loui 
Bulletin Board
e you looking o way o bing eal-woleconomic ino you claoom? Coniehee oouniie o un an ize by eneingyou high chool uen in one o boh o heewo ogam:
You can enter a team of ve students in the
Fed Challenge
, a moneay olicy comeiion inwhich uen ake a in a mock Feeal OenMake Commiee oum. A wokho o eache,eam an coache will be hel om 9:30 a.m. o1:30 .m. a each o hee Eighh diic ciie.
(Louiville wokho will be aangea high chool ie uon eque.)
Invite your students to enter the Hot Topics in
he New
essay contest
an ean ize anecogniion. Eay ae ue:
Fo moe inomaion abou eihe o heeogam, go o www.louie.og/eucaion.
o you have a gea iea o uing a Feeal reeve ublicaion in you claoom,o o you nee a gea iea o uing a Feeal reeve ublicaion in youclaoom? I o, vii
. A hiie, you can a a i o ool ha you wan o hae, an you can acce i anool ohe eucao have hae.
Feeal reeve reouce
Tips and Tools
Real-World Economics
New! Great Depression Curriculum
he Feeal reeve Bank o s. Loui ha eveloe a new cuiculum o eachingabou he Gea deeion. the cuiculum inclue ix an-alone leon haallow eache o ick an chooe hoe leon mo aoiae o hei uen.the leon inclue imulaion, gou wok, ole lay an ohe acive aegie oengage uen.I you each hioy, economic o govenmen, hi cuiculum i eec o you.We ae oeing wokho houghou he diic.
regional poeional develomen Cenerolla, Mo.9 a.m. – 2:30 .m.regie a: h://camu.um.eu/c/
Lile rock BanchLile rock, Ak.9 a.m. – 4 .m.regie a:www.louie.og/eucaion/coneence.hml
regional poeional develomen CeneCae Giaeau, Mo.9 a.m. – 2:30 .m.regie a: www4.emo.eu/c/
Memhi BanchMemhi, tenn.9 a.m. – 3 .m.regie a:www.louie.og/eucaion/coneence.hml
Hilton Garden HotelChestereld, Mo.
8:30 a.m. – 2:30 .m.regie a:www.louie.og/eucaion/coneence.hml
Economic Summit
for Secondary Teachers
University o Arkansas at Fayetteville
thi i a ogam o mile- an high-chooleucao who wan o lean abou cueneconomic iue an way o inegae heeiue ino claoom inucion.Fo moe inomaion, conac Julie Ke aJulie.A.Ke@l.b.og.

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