The Big Question: Why Are Gas Prices So Volatile?

 

Takeaway

  • Companies like Exxon, Chevron or Conoco couldn't manipulate the oil market, even if they wanted to, because they are too small relative to the size of the market. 
  • Oil prices are determined by the cost of producing "marginal oil," or the oil that is the most expensive to produce.

In the UT Energy Poll, Americans said they believe energy companies have the biggest influence on oil prices, including the price of gasoline. But reality doesn't match that perception. Finance Professor Sheridan Titman explains what really drives the month-to-month changes in gas prices

Movements in gasoline prices are driven mainly by changes in oil prices; U.S. energy companies have very little influence on oil prices. There’s no way a company like Exxon, Chevron or Conoco could manipulate the oil market, even if they wanted to. They’re too small, relative to the size of the market. 

Oil prices are determined by the cost of producing what I would call the marginal oil, or the oil that is the most expensive to produce. It’s very cheap to produce oil in places like the Middle East, but the amount of cheap oil is insufficient to satisfy demand. As a result, we also need to produce oil from places where it’s very expensive to produce, like the deepest part of the Gulf of Mexico. As worldwide demand to consume oil increases, prices need to increase to justify this high-cost production.

The recent increase in U.S. domestic production does have an effect on prices, but in terms of prices at the pump, the effect is probably pretty small. The world oil supply is 80 to 90 million barrels a day. We may add another 1 percent to that. In terms of world oil prices, it doesn’t matter whether we drill here or in Africa. But the increase in domestic production is good for the economy. If we produce one million more barrels per day because of shale oil, that’s $100 million per day we’re keeping in this country, rather than sending abroad.

And the recent discussion of financial market speculation affecting oil prices doesn’t make a lot of sense. The important thing to understand is that what we are observing in the future market is simply bets on the price of oil, and for everybody betting one way, there has to be someone betting the other way. Saying that bets on oil prices affect the actual price of oil is like saying that when I bet on a football game, it affects the outcome of the game. It’s possible, but not likely.

Going forward, I expect to see prices continue to fluctuate around $100 a barrel. If the economy heats up quickly, there might be a short-term supply shortage, which could temporarily push prices up to $150 a barrel. Likewise, a worldwide recession could temporarily push prices down to $60 per barrel. The important thing to note is that suppliers of oil will cut back on production if oil prices fall to as low as $60 per barrel, but there’s a lot of potential supply out there at $100 a barrel that will put a lid on prices.

Sheridan Titman is the Walter W. McAllister Centennial Chair in Financial Services at McCombs and president of the American Finance Association. He is also the executive director of the Energy Management and Innovation Center (EMIC) at the university, which conducts the national UT Energy Poll twice a year.

This article originally appeared in the fall 2012 issue of OPEN, the McCombs School of Business alumni magazine.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

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About The Author

Sheridan Titman

Walter W. McAllister Centennial Chair in Financial Services, McCombs School of Business

Sheridan Titman is a professor of finance at The University of Texas at Austin and a research associate of the National Bureau of Economic...

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