Is anyone else having a case of oil-induced déjà vu? It seems like every Spring the national conversation inevitably turns to the creeping price of gas at the pump. Commentators and cable pundits are quick to lay blame on the nearest scapegoat and this year it seems like President Obama is the official whipping boy. Before we storm the White House, lets take a moment to dig a little deeper into what causes and affects the price of oil.

First, the United States consumes just under 20 million barrels of oil per day. This constitutes around 22% of the roughly 90 million barrels of oil that is consumed per day to sate global demand. It goes without saying that the United States is a huge player in the global oil market - not only are we the largest single market by far, we are also the world's 3rd largest producer of oil.  But because American demand is so great, we are also the world's largest importer of oil - relying upon foreign sources to satisfy our domestic demand. 

Despite what the rhetoric may be, current domestic crude production is about 5.6 million barrels/day, which is the highest since 2003. The White House recently noted that net oil imports as a share of total U.S. consumption declined from 57% in 2008 to 45% in 2011 - the lowest level in 16 years. Lots of talk has focused on opening the Arctic National Wildlife Refuge and more recently on approving the Keystone XL pipeline, but almost every economic expert has weighed in that both options would only provide minor boosts to global oil levels, do little to dent global crude prices, and take years before production could be ramped up. In fact, The U.S. Department of Energy projects that opening the Arctic National Wildlife Refuge and Outer Continental Shelf would reduce the price of gasoline by at most six cents — and this would not be seen for at least another decade. The important thing to remember is that the U.S. is not an economic island and that oil is a GLOBAL commodity with prices that are affected by events and factors entirely out of the control of our government.  Here are some of the chief factors that go into the price you're seeing at the pump: 

Crude Oil / Supply and Demand

The primary reason for high gasoline prices is very simple, world demand for oil is high and increasing (led by a boom in developing nations like Brazil, China, and India) and the available supply is limited. The biggest portion of the cost of gas goes to crude-oil suppliers. This is mainly determined by the world's oil-exporting nations, particularly the Organization of the Petroleum Exporting Countries (OPEC).

Big oil companies (like Exxon and Shell) make most of their money by producing crude oil. Since the market price is now over $100/barrel, these large producers are raking in the money - but they are NOT setting the price. Major oil producers, like farmers, are the beneficiaries of high market prices, but they can no more control those prices than a farmer can dictate what he gets for a bushel of corn. As you can see in this chart, roughly 75% of the pump price is determined by the price of crude.  But let's be clear here - OPEC and other major oil producing nations can set crude production but not price, so what else can affect the price of crude besides basic supply and demand?

(Source: U.S. Dept. of Energy)

Socio-Political Instability

Yes, we live in a globalized world.  This means that events thousands of miles away can directly affect us.  2011 and 2012 have thus far been rather turbulent; from the on-going global recession, debt-worries in Europe, major unrest in the Middle East, and an unwieldy Iran, it's no wonder that pressure on crude prices has been increasing. While the U.S. may only get 18% of its crude oil from the Middle East, the global wholesale market for oil is interconnected and a threat from Iran to close the Straight of Hormuz can cause a domino effect of increased risk hitting Europe, Asia, and the U.S.  Who actually decides on bid and sell prices for oil on the global wholesale market?

Oil Traders and Speculators

Again, while oil production may be agreed to by heads of the major oil companies, shady jet-setting sheikhs, and totalitarian dictators, the price of crude is actually set in the open-market/oil exchange in New York City. Make no bones about it, this is called the free market - the same free market that our elected leaders on both side of the aisle champion. Throughout history free markets have shown to be more efficient than any other method of allocating value to goods, services, and commodities --- however, the introduction of condoned speculation has thrown this system for a loop.

Financial derivatives allow investors to make speculative bets on things like simple commodity futures contracts to more complicated financial instruments such as credit default swaps. Oil futures contracts are just another type of financial derivative, but they are a major cause of skyrocketing gas prices, not President Obama. The main purpose of oil futures, just like any other financial derivative, is to spread financial risk and uncertainty. Companies that need cheap fuel to stay financially solvent (e.g. airline companies) can use oil futures to hedge against the risk of future high gas prices. This is the proper use of financial derivatives. But the simple fact is that stock and commodity exchanges are dominated by financial speculators, not hedgers or investors.

Speculators invest money in financial instruments, but their goal is not to invest long-term. Their goal is to make quick profits off short-term fluctuations in price. Oil speculators are no different. According to a report from the St. Louis Federal Reserve, oil speculators can increase gas prices by at least 15 percent.  Speculators are not investors; they are professional gamblers. They have turned the New York Stock Exchange into a mega-casino. This view isn’t new; John Maynard Keynes thought the same thing during the 1930s when he described the failings of the NYSE by writing, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

There are solutions to stop speculation in oil futures trading. The Commodity Futures Trading Commission has written position limit rules that would regulate how much traders could buy in oil futures. This would reduce excessive speculation in oil futures.  This rule hasn’t gone into effect yet because industry groups such as the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association filed a lawsuit in December to stop the rule from being fully implemented.

Republicans are correct about one thing: the price of oil is not about to drop soon. With fear and uncertainty surrounding the situation in the Middle East and the threat of Iran’s nuclear program escalating, oil speculators are going to bid the price of oil futures up until financial speculators are taxed or regulated better.

What Can You Do?

Unfortunately, unless you own an oil producing rig, you don't have much influence in dictating the price of oil.  You've heard it before, but the most effective response to an increase in gas prices is to reduce our usage of gas, either through driving less or increasing fuel efficiency. Surprisingly, the best way to increase fuel efficiency is to keep your tires inflated. Longer term, we can change our need for oil and gas by switching to alternative fuel vehicles, using public transit, and moving closer to work to reduce commuting time. This will reduce the impact of gas prices on each of us individually by reducing use.

In the meantime, take some solace in the fact that the average price at the pump in London UK is £1.34 per litre, which equates to $8.14823 per gallon!

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