Hal Varian: Markets at Work in Oil and Gasoline

Lynne Kiesling

Hal Varian makes a persuasive argument and does us all a great service with his Economic Scene column in today’s New York Times (registration required). He focuses on two specific aspects of the workings of oil and gasoline markets: storage arbitrage and the role of speculators.

Storage arbitrage explains why, even if you have gasoline in storage that you paid a lower price for, you’ll still raise your price to buyers. Your incentive to do that is independent of whether or not the market in which you operate is competitive, an oligopoly, or a monopoly:

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.

Varian also debunks the idea that ill-informed and naive speculators will contribute to systematic increases in the prices of commodities like oil; sure, they may push prices in one direction or another in the short run, but if they don’t profit they will exit. Thus the involvement of speculators in the market actually serves to stabilize prices; they are part of a self-regulating system. He reminds us that Milton Friedman made this argument long ago, and that notwithstanding some criticism, his argument has been borne out:

Mr. Friedman’s 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 — 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.

Yes yes yes.


8 thoughts on “Hal Varian: Markets at Work in Oil and Gasoline

  1. In reality there would be offerings today even if the $2.10 next week figure is widely believed.

    Some sellers will believe $2.10 totally and will not sell for less. Others will be less sure and would sell today at $2.09, others at $2.08, etc.

    Some people sell stocks while believing they will be higher soon. They don’t believe it enough to keep that money in stocks rather than a nice CD now paying 6%+.

    And gasoline traders, with money tied up in gasoline, will act the same.

  2. A useful aphorism I’ve seen attributed to Joe Kennedy states that “Only a fool holds out for the last dollar.” Fools who do so often get caught by price reversals. At the moment, retail gasoline prices in my area are falling fairly rapidly.

    And gasoline traders, with money tied up in gasoline, are probably paying interest on that money, and may be better off selling out at a smaller profit now and turning less of that profit over to the cent percenters.

  3. A useful aphorism I’ve seen attributed to Joe Kennedy states that “Only a fool holds out for the last dollar.” Fools who do so often get caught by price reversals. At the moment, retail gasoline prices in my area are falling fairly rapidly.

    And gasoline traders, with money tied up in gasoline, are probably paying interest on that money, and may be better off selling out at a smaller profit now and turning less of that profit over to the cent percenters.

  4. The argument assumes no storage costs, and no marginal cost of capital; in fact, the price at which they’re willing to sell today will be a bit lower because (as noted by triticale) they can earn a week’s interest on the $2.10 and, typically, forego some expenses related to storage. In oil, the two factors add up to about 50 cents per month per barrel. This doesn’t change the qualitative point of the article.

    It should be noted, though, that it’s not actually necessary that the speculator in oil hold out in hopes that the expected price materialize; they can typically sell the oil forward. The actual arbitrage here is a purchase on the spot market and a future sale at the point at which prices quit increasing by 50 cents per month out; the oil can be delivered in satisfaction of the contracts at a guaranteed profit. A few months ago, September was the optimal sale point, but oil storage was largely full; the arbitrage argument, naturally, assumes that one is able to store oil, and building new storage facilities itself takes time, so once the exisiting facilities fill up the upper bound on the spread becomes a lot softer. (I don’t know the situation at this point.)

    The fact that oil a few months out has been higher for a while than spot oil (along with various other information, such as a lack of global excess capacity for production) makes it easy to imagine a picture of oil prices being driven by the futures, which are concerned with the possibility of an upside shock, and drag the spot price up. The futures a couple months out seem — I haven’t run numbers on this — to be more volatile than the near-run numbers, which feels like support for this view.

  5. Actually, I would like to see a study of how well futurers and/or commodity traders do.

    I suspect that it is not all that well.

    To start with these are nearly zero sum markets except for what some firms with real business needs to hedge are willing to pay for a hedge —
    compared to the total volume I suspect this is not that big. But to the extent that it is a zero sum market every gain by one trader is offset by the loss from another trader.

    Second, I see the large operation the CBO conducts to attract and train a constant stream of new entrant — and their capital — into the markets. If it were such a profitable business why would the existing members be so eager to attract new entrants? Are all these new entrants
    needed to replace those traders losing their capital — in other words does the CBO needs a constant stream of new suckers?

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