# Presentation: 941645

## Factors Impacting Gasoline Prices and Areas for Further Study

**John Cook**
**Energy Information Administration**
**FTC Public Conference**
**August 2, 2001**

**Notes:**
This briefing summarizes EIA analysis to date that suggests:

Most, if not all, recent retail gasoline price movements can be explained by market fundamentals, I.e., underlying movements in supply, demand, and inventories in crude oil and wholesale gasoline markets; and

Even “downward sticky” retail price behavior is the expected pattern, not the result of market imperfections.

## Different Factors Impact Different Aspects of Gasoline Price

- Source: EIA Monthly Retail Prices, Reuters Spot Regular Conventional Gasoline Prices, EIA Refiners Acquisition Cost of Crude OIl

**Notes:**
In order to illustrate and quantify, to a large extent, the various market forces driving gasoline prices, we begin by decomposing those factors according to their location within the supply chain, i.e., the international crude market, U.S. wholesale gasoline markets, and the retail segment.

Historically, variation in gasoline prices usually stems from changes in crude oil prices.  As the major feedstock in the production of gasoline, shifts in the balance between supply and demand in crude markets explain a large portion of observed movements at the retail level.  

But shifts in the wholesale gasoline supply/demand balance also contribute to price pressure or movements at both the wholesale and retail levels beyond that stemming from crude oil markets.

Hence, to explain gasoline price behavior, we examine the drivers underlying:
International crude oil prices (which impact more than just crude oil prices)
Crude oil to spot prices 
How crude market influences product markets
Domestic gasoline market contribution
Gasoline price volatility
Spot prices to retail prices: Do retail prices rise quickly but fall slowly?  That is, are they downward sticky?

## Correlation of Price to Inventory Levels

**Source: EIA**

**Notes:**
Gasoline prices move with changes in crude oil prices, and crude prices have varied significantly over the past decade, as illustrated above with the monthly average spot prices for West Texas Intermediate crude oil.  Gasoline prices were as low as 91 cents per gallon in early 1999 when crude prices were very low, and were around $1.56 per gallon mid to late September 2000 when crude prices were high, even though the peak gasoline demand season was over at that point.

We have observed that crude oil., like other commodities, responds to basic market fundamentals of supply and demand.  Inventories are a good means of measuring the balance between demand and supply in the marketplace, and thus are a good barometer of price pressure.  For example, when demand exceeds supply over and above the typical situation, inventories fall, and prices rise.  

The graph illustrates the correlation.  For example, from the end of 1996 through 1998, inventories were building.  This was the time period when Iraqi crude oil came back into the market, and the Asian financial crisis reduced Asian demand growth.  Production exceeded demand, inventories built, and prices fell. 

OPEC took action to reverse the situation with a series of cutbacks that removed excess production from the market.  At the same time Asian economies were recovering, adding demand pressure to the market.  Demand exceeded production, inventories were used to help meet demand, and they fell to very low levels.  Prices rose in conjunction.  

## Crude Prices Strongly Related to OECDCrude & Product Inventories

**Crude Prices Strongly Related to OECD****Crude & Product Inventories**

**Source: EIA and OECD**

**Notes:**
EIA has quantified this relationship, and this graph shows the results.  The graph shows the model as it begins predicting prices in 1992.  It shows how well the model has predicted not only the direction, but the magnitude of prices over this 8+ year period.

 While the model is simple and not perfect, it does predict the overall trends and, in particular, the recent rise in prices. 

 It also shows that prices may have over-shot the fundamental balance for a while this past fall -- at least partially due to speculative concerns over Mideast tensions, winter supply adequacy, and Iraq’s export policies.

 While prices diverge somewhat from the model results in any given month, they tend to drift back to levels supported by the fundamental supply/demand balance, as movements based on expected behavior can be sustained only if supported eventually by market fundamentals.  The important point is that most of the movement or variation in crude oil prices is explained by market forces as represented by relative inventory levels.  

## Gasoline Prices Also Influenced by Regional Gasoline Product Markets

**Source:  History -- EIA**

**Notes:**
Next we examine the wholesale market’s added contribution to gasoline price variation and analyze the factors that impact the gasoline balance. There are two points to take away from this chart:
The U.S. market moves with the world market, as can be seen with the high inventories in 1998, being drawn down to low levels during 1999.
Crude and product markets are not independent.  Crude oil and product markets move together fairly closely, with some lead/lag effects during transitions.

The relationship between international crude oil markets and domestic product markets raises another issue.  A subtle, but very important point, lost in recent discussions of gasoline price increases:  
The statement has been made that crude markets are not a factor in this past spring’s high gasoline prices, since crude prices were relatively constant during that period.  
This misses the crucial point that international petroleum markets set the stage for the gasoline price increases we experienced.  The international market tightened, reducing inventories for both crude and products to very low levels this spring.  There was no cushion for unexpected changes in supply or demand.  This lack of cushion set the stage for this spring’s price runup.  
Other factors, such as little excess refining capacity and distribution system constraints, were also at work, which EIA has discussed in recent testimony and elsewhere.  But crude markets had an important role in this spring’s price runup.  Had inventories been high, we likely would not have seen prices rise as much as they did.

## Tight Product Balance Pushes Up Product Spread (Spot Product – Crude Price)

**Source: Reuters**

**Notes:**
To reinforce the impact that inventory levels (I.e., tight markets) have on price, note the variation in spot gasoline prices relative to crude oil prices, as shown by the blue band.

Gasoline inventories indicate how tight the gasoline product market is in any one region.  A tight gasoline market (i.e., inventories are low) generates upward pressure on spot prices beyond that attributable to crude markets.  That is, wholesale prices are bid up by more than any underlying cost increases.  This upward movement relative to crude prices can be measured or seen as an increase in the spread between spot gasoline prices and crude oil prices.  

The price spread between gasoline and crude oil normally rises in the spring and summer months, but the rise is greater in years when stocks are low.  Compare 1999, when stocks were high to this year and last year, when stocks were low.

But from the last slide, we showed how gasoline inventories are influenced by overall crude markets.  Since the low gasoline inventories are not only influenced by local product markets, but also by the overall international petroleum market, the spot gasoline price is influenced by both markets.

The remaining charts consider how this spot price is reflected or “passed through” to retail customers.

## Retail Price Changes Lag Spot Prices

**Notes:**
While EIA cannot claim to explain all of the factors that drive retail gasoline prices, we have had a fair amount of success in exploring the relationship between wholesale and retail prices.  In particular, we have looked closely at the “pass-through” of changes in spot prices to the retail market.

This graph shows a weighted national average of spot prices for regular gasoline –both conventional and reformulated (shown in red), and EIA’s weekly survey price for retail regular (again both conventional and reformulated).  As you can see, spot prices tend to be more volatile (and would be even more so on a daily basis), while these changes are smoother by the time they reach the retail pump.  Furthermore, by looking at the peaks, you can see the retail prices seem to lag the spot price changes slightly.

EIA econometric analysis demonstrates that the typical price pattern at the retail level (i.e., downward sticky price changes) are almost completely explained by the lagged pass-through of prior wholesale changes.  If spot prices were to jump 10 cents this week, for instance, part of that increase would show up at retail next week, but the remainder would be spread over the following weeks.  In fact, we have found that it can take as long as eight weeks or more to pass through the entire effect, though the majority is seen within the first few weeks.

This effect can explain some of the seemingly anomalous behavior of retail prices in relation to wholesale.  For instance, at the end of a sharp rise or fall in spot prices, retail prices may continue to move in that direction even after spot prices have changed course, because the previous increase (or decrease) is still being passed through.  Also, many have claimed that gasoline prices rise faster than they fall.  EIA’s research has shown that this apparent “asymmetry” is mostly an artifact of the lag in price pass-through from wholesale to retail.

## Cumulative Gasoline Price Pass-through

| Week | New England | Central Atlantic | Lower Atlantic | Midwest | Gulf Coast | West Coast |
| --- | --- | --- | --- | --- | --- | --- |
| 1 | 16% | 13 | 15 | 39 | 12 | 21 |
| 2 | 28 | 26 | 32 | 60 | 31 | 40 |
| 3 | 38 | 37 | 43 | 71 | 41 | 50 |
| 4 | 50 | 48 | 53 | 79 | 50 | 60 |
| 5 | 61 | 57 | 64 | 85 | 58 | 69 |
| 6 | 69 | 66 | 72 | 92 | 66 | 76 |
| 7 | 74 | 73 | 77 | 100 | 73 | 83 |
| 8 | 78 | 80 | 85 |  | 79 | 88 |

**Notes:**
The rate at which prices are passed through from wholesale to retail varies regionally, for a number of reasons, not all of which we fully understand.  For example, for whatever reason, changes in wholesale prices show up relatively quickly at retail in the Midwest.  

However, it’s important to note that this process still takes a total of 7 weeks, and that the lag is fairly consistent in both directions – rising and falling.

## Illustration of How Lag Effect Dampens and Slows Retail Price Changes from Wholesale

**Notes:**
This example illustrates in a simple way how the lag effect keeps retail prices from dropping as fast as they rise.  

Before the retail price has reflected all of a wholesale price increase (10 cents), the wholesale price usually begins to fall.  The decrease in the wholesale price begins to be passed on to the consumer on top of the remaining wholesale price increases, which slows the retail price increase.  The net result is to dampen the rise and fall of retail prices relative to wholesale prices, to cause retail prices to peak later than wholesale prices, and to cause retail prices to fall at a slower rate than they rise.  The retail market simply reflects the wholesale price changes spread out over a longer time. 

## Recent Weekly Retail Price Changes Have Been as Expected

**Notes:**
Using the results of this research, EIA has been able to create a model that takes observed changes in spot prices over the previous weeks, and forecasts what this week’s retail price change will be.  As you can see from this chart, we’ve been fairly successful.  

This chart shows that the model is quite accurate at forecasting one week ahead.  In fact, in the first 28 weeks of this year, our model correctly forecasted the direction of the retail price change 26 times, for an accuracy rate of 93 percent .  Additionally, as you can see, most weeks it did a very good job of forecasting the relative magnitude of the increase or decrease in retail prices.  We’re still refining this model, and customizing it for each region, so we’ve got quite a bit of work left to do.

So what does this show us?  To the extent that we can show a consistent relationship between wholesale and retail price movements, and even duplicate that behavior via a model, it would appear that no significant anti-competitive behavior is occurring in the marketing chain, at least beyond the spot price level, which is essentially the “refinery gate” or point of import.

Of course, national average prices do not show what may be happening at a local level.  But as we further develop this model, we will be able to state more definitively whether the relationship between spot and retail gasoline prices is as consistent on a regional basis.  We also hope to be better able to understand what happens in a price spike, which is the most difficult phenomenon to explain statistically.

## Summary: Most Gasoline Price Movement Can Be Explained As Rational Market Behavior

**EIA’s work to date has demonstrated rational market behavior behind gasoline prices**
**While much price variation can be explained, there is room for further study**

**Notes:**
EIA’s conclusion about gasoline prices to date is that rational market behavior seems to explain most of the variation we see in prices.  We have reached this conclusion by studying the components of price, as described briefly in this presentation.  

However, there are still questions to be explored further, such as why we see the variation in pass through in the Midwest compared to other regions.