Gas Prices Are Not Tied to Oil Prices

Most people think gas prices reflect oil prices, but they don't. Ed Wallace explains why—and why gas prices still go up when oil falls

By Ed Wallace

"The price of gas is indeed tied to oil. It's just a matter of which oil." —Associated Press, Feb. 15, 2009

With statements like that, it's no wonder Americans don't understand how the energy industry really works. But that line appeared in an Associated Press story that ran Feb. 15 and was reprinted in virtually every major newspaper in America. The statement simply feeds and sustains the public's conviction that oil and gasoline costs are directly linked to one another—which they're not: There is an connection between oil prices and gas prices, but it is indirect— far less strong or predictable than most people understand.

The AP story concluded that gas prices are rising while the price of some oil is falling because American refineries are primarily using oil from overseas, not the U.S. benchmark crude West Texas Intermediate. No news there; there isn't enough WTI crude to supply this nation's fuel needs. Not even close.

Then the writers suggest that the cheaper WTI, which they incorrectly refer to as West Texas International, could play a bigger part in our oil system if only pipelines were built to transport this crude past "refineries in the Midwest." That statement could be true, but it's not. In fact, it reveals a deep unfamiliarity with WTI's NYMEX contracts, because they specifically state that anyone bidding for West Texas Intermediate must deliver that oil to the storage tanks at Cushing, Okla. Spot-cash prices for immediate delivery of WTI allows shipment elsewhere, but that’s not the basis for the price discovery system.

Low-Tech Controls Still Work

The Cushing clause was designed to dampen wild swings in oil prices. If the tanks at Cushing were full, that would put downward pressure on the price for WTI; there would be no sense in purchasing that oil if storage space wasn't available, so the price would fall. Likewise, when Cushing's storage tanks were low, the price of oil could float upward to refill the space available. This may sound like an overly simplistic way to moderate the price of oil, and it is. And if you think this system needs to be updated or scrapped, fine. Change it if you want. But this was the original intent of WTI NYMEX contracts' demanding delivery at Cushing, and the contracts still specify that location. (Crude other than WTI can also be stored at Cushing.)

It should be noted that when British Petroleum (BP) purchased Arco in 2000, one of the Federal Trade Commission's conditions for approving that purchase was that BP would have to sell Arco's pipelines and storage tanks at Cushing, to remove the possibility of any manipulation of WTI contracts. That would also mark the last time the U.S. government expressed any concern about oil price manipulation.

The AP story suggests that the price of gasoline is going up because the futures market for oil is now weighted in favor of Brent Sea North, an oil contract that has traded for $7 to $10 higher than WTI. Here again, the article left a key factor out of the equation: Brent Sea oil's price was sitting around $44 per barrel, not far from where it was the first week of December, and yet the price of gasoline on the futures market has climbed from under 85¢ per gallon to over $1.24 at one point ($1.08 per gallon as of publication). So yes, Brent Sea North is higher than West Texas Intermediate, but it has been higher for months. If AP's theory were correct, gasoline prices would have remained static.

Don't Compare, Contrast

The AP story briefly mentions but doesn't make clear the real issue: The gasoline futures market is not the oil futures market. The real reason gas prices are moving upward is that gasoline is sold under a completely separate futures contract and to different buyers than oil is.