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August 24, 2006
Economic Scene

The Rapidly Changing Signs at the Gas Station Show Markets at Work

By HAL R. VARIAN

THE recent gyrations in oil prices offer a textbook illustration of how financial markets and commodity markets interact.

Oil prices are notoriously volatile, particularly when times are tense in oil-producing countries ó just about all the time these days. So when BP announced this month that it might have to suspend as much as 8 percent of the nationís oil production because of corrosion in pipes on the North Slope of Alaska, the price of crude oil immediately shot up by 3 percent and wholesale gasoline prices simultaneously increased by about 2 percent.

But why? Even if it will cost more to produce gasoline in the future, gasoline being sold today was made with cheaper oil. This must be a rip-off, right?

Actually, no. The reason behind the quick price change is a phenomenon known as storage arbitrage.

To spell out the argument, imagine that you own a storage tank full of gasoline that is currently worth $2 a gallon at wholesale prices. It is widely believed, however, that the price of gasoline will be $2.10 next week.

You would be crazy to sell your gasoline now: just wait a few days and the higher price will be yours. But if everyone waits a few days, there is no gasoline to be sold now and the resulting shortage pushes the price of gasoline up.

How high does it have to go? The answer is $2.10 a gallon. That is the price necessary to induce those who have gasoline to sell it now rather than to wait till next week.

This argument does not depend on whether you think the gasoline market is a paragon of perfect competition or an evil oligopoly. All it requires is that you believe that people who own gasoline, like just about everybody with something to sell, prefer to receive a higher price rather than a lower price.

Even if the price of gasoline were set by a perfectly benevolent conservationist, we would expect to see the same pattern of price movements. If oil will be scarcer in the future because of the BP pipeline shutdown, we would want to conserve the already-produced gasoline that we have now. That means that the price of gasoline has to rise right away to prevent hoarding and to encourage conservation.

Storage arbitrage arguments were featured in a recent article in the Sunday Business section of The New York Times with the headline ďIs a Futures Stampede Keeping Oil Prices High?Ē The article described a provocative report written by Ben P. Dell, an analyst at Sanford C. Bernstein & Company, that blamed speculation in oil futures markets for high oil prices.

Mr. Dellís argument was that inexperienced institutional investors had been investing in contracts for future delivery of oil, driving up futures prices. If the price of oil to be delivered in the future goes up, it has to pull the current spot price up as well.

There is no risk associated with holding the oil in storage since owners can sell futures contracts, collecting a payment now to deliver the oil later. If you donít happen to have a tank of oil in your backyard, that is not a problem: just go out and buy some on the market. The article pointed out that on Aug. 4 it was possible to ďbuy heating oil in New York Harbor at $2 a gallon and store it and sell a future to deliver it in December for $2.24.Ē

Perhaps Mr. Dell is right that speculation in the oil futures market is driving up spot prices. But we should not expect that to be the normal situation. As long ago as 1953, Milton Friedman argued that speculation normally helps to stabilize prices rather than destabilize them.

Mr. Friedmanís argument was applied to currency trading, but the same reasoning works here. If speculative trading tends to push prices higher when they are already high and lower when they are already low, then traders must be buying high and selling low.

That would mean that traders have to lose money on average ó which does not seem very likely. To the contrary, speculative traders try to buy low and sell high, activities that by their nature tend to push prices up when they are too low and down when they are too high.

Since Mr. Friedmanís 1953 article several papers have been published, both supporting and attacking this argument. But the general principle seems quite robust.

Mr. Dellís report specifically cited the rush of new and inexperienced traders into commodities markets as the cause of the current problems. Mr. Friedmanís argument was a long-run argument: speculators who bought high and sold low would be driven out of business.

But there is no reason speculators cannot lose money in the short run, particularly if they are inexperienced. Mr. Dell says that storage facilities are now close to capacity, which will make it more difficult to play the arbitrage game in the future. Indeed, crude oil prices have declined nearly 8 percent in the last two weeks.

If speculators start to worry that the price of oil could soon be significantly lower, some of that stored oil would come back on the market, pushing spot prices down, and offering welcome relief to consumers.

Hal R. Varian is a professor of business, economics and information management at the University of California, Berkeley.