I was looking though TH's editorial cartoons when I saw this one:



Of course people don't usually look to cartoons for great economic insight, but in this case it is such a common mistake that I feel the need to address it. Especially as the "mismatch" between oil and gas prices is one of those "proofs" that people use to malign oil companies and accuse them of "gouging".

Let us make a simple point many seem to forget, oil is not gasoline. Gasoline is a refined product. What is more, gasoline prices are not set by the big oil companies. The oil companies sell to distributors who sell to individual gas stations, making the consumer price several steps removed from oil prices.

But more important is the time difference. Oil prices today are set by the demand for immediate delivery of oil, as well as expectation of future prices. However, the bidders are the refineries, who expect to have a relatively constant influx, meaning prices have little future expectation built in. If a dramatic rise is expected, then speculation will drive it up somewhat, at least until they cash in and drive prices down once again, but in relatively flat periods, prices tend to represent immediate supply and demand more than anything.

On the other hand, gas prices represent the expected cost to replace sold gasoline sometime in the future when supplies run out. Depending on the size of tanks and volume of sales, this could range anywhere from a few days to a few weeks in the future. Similarly, the prices set by the distributors reflect the expected replacement costs when they need to restock. In both cases, the prices reflect an expectation of future market prices.

And thus there is not necessarily any connection between the trend in gasoline prices and the trend in oil prices. If the market is saturated, but it is expected demand will rise in the next week, oil prices may be falling while gas prices are rising.

However, even that explanation ignores many factors.

The cost of gasoline is not tied only to the cost of oil. It also includes the cost of labor, the depreciation of plants, and the cost to transport, not to mention taxes. if any of those factors are rising, or expected to rise, the cost of gasoline may quickly rise while oil remains stable or falls. Similarly, when new refineries cannot be built, there is a limit on how much gasoline can be produced, causing prices to rise. However, at the same time, demand for oil is curtailed, making prices fall.

And that final point, all on its own could explain the whole phenomenon. But let us ask if there might not be other factors.

For example, our current economic problems make it hard to even consider building new refineries, even if the laws were more lax, which serves to exaggerate this problem. On top of that, the stimulus package's emphasis on "green" energy suggests that restrictions on refineries are not going away any time soon. Expecting a limited production capacity, gas stations are bidding up gasoline to ensure a share of the limited supply, while oil refiners maintain a low purchase rate in order not to be stuck with excess oil they cannot refine.

And then we have taxes. With the expectation of new taxes, many companies that need to make large purchases domestically may be doing so now, in order to avoid at least some of the future tax burden. They may also do so as they are uncertain about their economic situation and want to be sure they have stock on hand. Whatever the reason, these purchases will serve to drive up the local market for refined fuel, while again, the limited refining capacity will mean demand for oil will remain relatively flat. Once 100% capacity is in use, there really is no incentive to expand purchases.

And finally there are inflationary fears. You can see this in the rise of gold futures from $700 in November to $900 or more today. Though the press has completely ignored it, those who deal with money know what an unfunded $850 billion spending bill means, massive inflation. And that means that items purchased today will serve as concrete stores of value. And, in the case of those buying on credit, debts incurred today will be repaid in depreciated dollars. The large oil companies have other hedges against inflation, and, with caps on production do not have incentive to hold large reserves, but for the smaller enterprises, inventory serves as a good hedge against depreciation of the dollar.

Of course, none of this will stop people from looking for sinister motives and ascribing malice to the practices of oil companies. No matter how sensible such policies are, no matter how easily explained, inevitably those who fear "Big Oil" will see nothing but "gouging" in any disparity between oil and gasoline prices.