Full text of Inside the Vault : Fall 2007

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THE
An Economic Education Newsletter from the Federal Reserve Bank of St. Louis

Volume 12, Issue 2 Fall 07

Why Do Gasoline Prices React to Things
That Have Not Happened?
H
ave you ever wondered why gasoline stations raise their
prices in response to fears about future supplies of oil? You
may have thought to yourself, “I know the gasoline in the station’s
underground storage tank was purchased before the world price
increased. How can they raise the gas price now? The gasoline
market must be rigged.”
In fact, gasoline stations should raise their prices to reflect
increased future costs of replacing their inventories. Prices act like
engine or voltage regulators—they automatically speed up or slow
down the flow of the commodity in order to maximize performance,
or what economists call allocative efficiency. (Consumers get the
goods 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 that
might happen in the future, halfway around the world, one must
understand 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 oil
is the most volatile component; other factors, such as taxes and
profit margins, do not change often.
Oil and Gasoline Prices Move Together

90

350

80

Domestic Spot Market Crude Price: West Texas Intermediate, Cushing

70

Average U.S. Conventional Gasoline Regular Spot Price

300

$/Barrel

50

200

40

150

Cents/Gallon

250
SOURCES: Crude oil prices are from The Wall Street Journal.
Gasoline prices are from the U.S. Department of Energy.

60

be sold for immediate delivery or stored for sale in the future;
so, firms adjust their inventories in response to news about the
future 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. The
price at your local gas station will change nearly as quickly as the
wholesale price.
Let’s see how two hypothetical competing gasoline stations in a
small town might react to a sudden increase in the price of oil. On
one quiet morning, both the Conch Gas station and the Pegasus
Gas station were charging $1.999 per gallon of regular gasoline.
They each had bought their inventories a few days before at a cost
of $1.48 per gallon. With federal, state and local taxes combining
for 50 cents per gallon, each station calculated that it would make
about 2 cents per gallon at a retail price of $1.999.
During the late morning, news of an unsuccessful terrorist
attack on Saudi Arabian oil fields spurred widespread fears of
cuts in future oil supplies. As frenzied trading on exchanges
in New York, London and elsewhere bid up the world price of
oil, the station owners learned that wholesale gasoline prices for
delivery next week had increased by $1 per gallon. Both owners
raised their prices to $2.99 per gallon.
Despite much grumbling at the price increases, sales at the
Conch Gas and the Pegasus Gas stations proceeded much as
before—both stations sold out their existing inventories right on
schedule and then took delivery on a new load of gasoline at the
new, higher wholesale prices. The station owners made a tidy,
unexpected profit that week—$1.02 per gallon.

30
100
20
50

10

0

0
1988

1991

1994

1997

2000

2003

2006

The figure above shows that while gasoline prices can diverge
from oil prices for short periods because of seasonal demand, tax
changes or other reasons, the two prices are closely linked over
longer periods.
Because oil can be transported anywhere, trading on global spot
and futures markets determines the global price of a given grade of
oil, aside from local taxes and transportation costs. Oil can either

Are the Gas Stations Gouging Us?
Did the stations’ simultaneous price changes the week before
wholesale prices actually went up prove that Conch Gas and
Pegasus Gas were colluding to gouge consumers? No. These
competing station owners did not have much choice if they
wanted to remain as profitable as their competitors and stay in
business 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 Gas
obviously would have captured all of the traffic that day, but its
storage 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

A futures market is one in which a commodity is traded for delivery on a specified future date, which could be months
or years away. Major fuel users, such as
airlines and trucking companies, often
buy oil in futures markets to guarantee
the cost of the fuel they will use.

Q.
A.

Q.
A.

Grades of crude oil are determined
by their specific gravity and sulphur
content. There are so many different
varieties and grades of crude oil that buyers and sellers refer to a limited number,
which are called reference or benchmark
crude oils. Other varieties are then
priced at a discount or premium relative
to the benchmark. Brent blend crude oil
pumped from the North Sea is generally
accepted to be the world benchmark.
According to the International Petroleum Exchange, Brent is used to price
two-thirds of the world’s internationally
traded crude oil supplies. In the Persian
Gulf, Dubai crude is used as a benchmark to price sales of other regional

What is a commodity?

A commodity is a food, metal or
other fixed physical substance that investors buy or sell, usually through futures
contracts. Agricultural products, metals,
petroleum, foreign currencies, and financial instruments such as Treasury bills
and bonds are commodities. Petroleum
(crude oil) is the world’s most actively
traded commodity.

Q.
A.

What are the benchmark crude oils?

What are spot and futures markets?

A spot market is one in which
commodities are traded for near-term
delivery—within a month for oil markets.

crude oils to Asia. In the United States,
the benchmark is West Texas Intermediate (WTI). This means that crude oil
imports into the United States are usually
priced in relation to WTI. The Organization of Petroleum Exporting Countries
(OPEC), a cartel of some of the world’s
leading producers, has its own reference,
known as the OPEC basket, which is an
average of seven crude oils. Six of the
crude oils included in the OPEC basket
are pumped by member countries, and
the seventh is from Mexico. In practice,
however, price differences are not large.

The Q&A segment was largely adapted from: the
FAQ on Chicago Board of Trade web site, www.
cbot.com/cbot/pub/page/0,3181,1065,00.html, and
BBC News online, Oil Markets Explained, http://
news.bbc.co.uk/2/hi/business/904748.stm.

Economic Snapshot
Second Quarter 2007

(Percent change at an annual rate from the preceding period.)

Q3-’06

Q4-’06

Q1-’07

Q2-’07

Growth rate —
Real Gross Domestic Product

1.1%

2.1%

0.6%

4.0%*

Inflation rate —
Consumer Price Index

3.1%

–2.1%

3.8%

6.0%

Civilian Unemployment Rate

4.7%

4.5%

4.5%

4.5%

*Preliminary estimate

Nominal vs. Real Oil Prices

No. The grey line on the graph indicates that the real price,
i.e., the price adjusted for inflation, was highest in 1981, at
more than $39 dollars per barrel.

40
$/ BARREL

Were nominal prices for oil higher in 2006 than
in any other time during the period 1973-2006?

Were real prices for oil higher in 2006 than in
any other time during the period 1973-2006?

Real Refiner Acquisition Price of Crude Oil, 1982-’84 dollars
Nominal Refiner Acquisition Price of Crude Oil in That Year’s Dollars

50

Nominal prices, sometimes called current dollar prices,
measure the dollar value of a product at the time it was
produced. Real prices are adjusted for general price level
changes over time, i.e., inflation or deflation. These adjustments give us a picture of prices for various years as if the
value of the dollar were constant.

Yes. The blue line on the graph indicates that the price
per barrel in current dollars, i.e., the nominal price, was
approximately $60 per barrel in 2006.

70
60

What is the difference between nominal and
real prices?

30
20
10
0
1973

1976

1979

1982

1985

1989

1991

1994

1997

2000

2003

2006

SOURCE: The Federal Reserve Bank of St. Louis

Bulletin Board

Real-World Economics

A

re you looking for ways to bring real-world
economics into your classroom? Consider
these opportunities for fun and prizes by entering
your high school students in one or both of these
two programs:

New! Great Depression Curriculum

T

he Federal Reserve Bank of St. Louis has developed a new curriculum for teaching
about the Great Depression. The curriculum includes six stand-alone lessons that
allow teachers to pick and choose those lessons most appropriate for their students.
The lessons include simulations, group work, role play and other active strategies to
engage students.
If you teach history, economics or government, this curriculum is perfect for you.
We are offering workshops throughout the District.

Oct. 25, 2007

Jan. 17, 2008

Regional Professional Development Center
Rolla, Mo.
9 a.m. – 2:30 p.m.
Register at: http://campus.umr.edu/rpdc/

Memphis Branch
Memphis, Tenn.
9 a.m. – 3 p.m.
Register at:
www.stlouisfed.org/education/conferences.html

Nov. 9, 2007
Little Rock Branch
Little Rock, Ark.
9 a.m. – 4 p.m.
Register at:
www.stlouisfed.org/education/conferences.html

Nov. 27, 2007

Feb. 6, 2008
Hilton Garden Hotel
Chesterfield, Mo.
8:30 a.m. – 2:30 p.m.
Register at:
www.stlouisfed.org/education/conferences.html

Regional Professional Development Center
Cape Girardeau, Mo.
9 a.m. – 2:30 p.m.
Register at: www4.semo.edu/rpdc/

• You can enter a team of five students in the
Fed Challenge, a monetary policy competition in
which students take part in a mock Federal Open
Market Committee forum. A workshop for teachers,
teams and coaches will be held from 9:30 a.m. to
1:30 p.m. at each of these Eighth District cities.
• Oct. 16, 2007 – Little Rock, Ark.
• Oct. 17, 2007 – Fayetteville, Ark.
• Nov. 14, 2007 – St. Louis
• Dec. 5, 2007 – Memphis, Tenn.
(Louisville workshops will be arranged
at high school sites upon request.)
• Invite your students to enter the Hot Topics in
the News essay contest and earn prizes and
recognition. Essays are due:
• Dec. 14, 2007 – St. Louis
• Jan. 11, 2008 – Little Rock, Ark.
• Feb. 15, 2008 – Memphis, Tenn.
• April 4, 2008 – Louisville, Ky.
For more information about either of these
programs, go to www.stlouisfed.org/education.

Economic Summit
for Secondary Teachers

Federal Reserve Resources

Nov. 12, 2007
University of Arkansas at Fayetteville

8:30 a.m. – 5 p.m.

Tips and Tools

D

o you have a great idea for using a Federal Reserve publication in your classroom,
or do you need a great idea for using a Federal Reserve publication in your
classroom? If so, visit www.stlouisfed.org/education/resourcetools. At this
site, you can add a tip or tool that you want to share, and you can access tips and
tools other educators have shared.

Bank
Contacts

Little Rock – Billy Britt 501-324-8368
Louisville – David Ballard 502-568-9257
Memphis – Jeannette Bennett 901-579-4104

This is a program for middle- and high-school
educators who want to learn about current
economic issues and ways to integrate these
issues into classroom instruction.
For more information, contact Julie Kerr at
Julie.A.Kerr@stls.frb.org.

St. Louis – Dawn Conner 314-444-8421
St. Louis – Mary Suiter 314-444-4662

continued from front cover

oil market, the owner-manager of Conch
Gas might as well have gone on vacation—unpaid, it should be noted. Meanwhile, the manager of Pegasus Gas—who
took his vacation in the first two days of
the crisis—returned to sell out his remaining inventory at $2.999 per gallon. In the
end, the Pegasus Gas station made a much
larger profit.
Now suppose that both Conch Gas
and Pegasus Gas decided to show hometown solidarity by keeping their prices at
$1.999, at least until the new, higher-cost
gasoline inventories arrived in a few days.
Local residents certainly would have been
appreciative, but so would all of the eager
drivers from neighboring towns who would
have driven in to enjoy “cheap” gas. Both
the Conch and Pegasus stations would have
run dry before their replacement inventories arrived. Anyone in this town who was
unfortunate enough to need gas on the third
day of the crisis would have been out of luck.
What if all the gasoline stations in the
state had agreed to keep their prices at
$1.999 until higher-cost supplies started
arriving? Even if the flow of out-of-state
bargain hunters might turn out to be small,

a state-wide shortage of gasoline would
almost certainly result. Recognizing that
gas prices were only temporarily low
and were bound to rise soon, all rational
owners of cars, trucks, tractors, off-road
vehicles, lawn mowers or leaf blowers
would fill up their tanks as quickly as possible. That is, any attempt to constrain the
retail price of gasoline in the face of higher
future prices simply induces a scramble
among buyers to beat the price increase.
Many people would make wasteful extra
trips to top off half-full tanks, and others
would be genuinely inconvenienced as
shortages developed.
Thus, the simultaneous price increases
by Conch and Pegasus Gas are not harmful
price gouging at all. Although no one likes
to pay more for gas, market-determined
gasoline prices operate to prevent shortages
and maximize economic efficiency.
This article was adapted from Why Do
Gasoline Prices React to Things That
Have Not Happened?, which was written by
William Emmons, a senior economist at the
Federal Reserve Bank of St. Louis, and
Christopher J. Neely, an assistant vice
president at the Federal Reserve Bank of

Classroom Discussion
1. How do prices in a market economy
serve as a signal to producers and
consumers?
2. If prices in a market economy were
not allowed to rise when a commodity was becoming relatively
more scarce, how would producers
and consumers discover that the
commodity was in short supply?
3. If prices are not allowed to rise
as a commodity becomes in short
supply, what are some methods
that society could use to ration the
scarce commodity, and how efficient would these methods be?
St. Louis, and was published in the July issue
of The Regional Economist, a St. Louis Fed
publication.

For a lesson plan to accompany this
article, go to www.stlouisfed.org/
education/itv_lesson_plan.html.

prsrt std
U.S. POSTAGE
PAID
ST. LOUIS, MO
PERMIT NO. 444

Federal Reserve Bank of St. Louis
P.O. Box 442
St. Louis, Mo. 63166-0442
Inside the Vault is written by
Dawn Conner, economic
education coordinator, and
Mary Suiter, manager of
economic education, at the
Federal Reserve Bank of
St. Louis, P.O. Box 442,
St. Louis, Mo., 63166. The
views expressed are those of
the authors and are not necessarily those of the Federal
Reserve Bank of St. Louis or
the Federal Reserve System.
Please direct all comments
and questions about the publication to 314-444-4662 or
mary.c.suiter@stls.frb.org.