What’s Behind the High Gas Prices at the Pump?

Planning a budget is hard enough without having to deal with expenses that tend to move wildly from week to week, especially an expense as big and as important as gasoline. Normally, most of us have a pretty reasonable idea of how much gas and diesel we will be using in any given week, as our driving patters seldom change. But recently, we have seen prices for gasoline and diesel skyrocket at a time when they are usually weak.

Instead of just guessing where prices will go, you can make a reasonable estimate by doing a little analysis of the oil markets. Now, this is more of an art than a science, so you’ll seldom hit the nose right on the head. But if you try hard enough, you can get somewhat close. There are a bevy of factors to consider when examining curious short-term shifts in gasoline prices. The most defining factor, unfortunately, is market sentiment.

When traders, refiners, producers and investors feel nervous about gasoline supplies, for whatever reason, you can bet prices will go up, even if all the data suggests that prices should be going down. Iran is currently the market’s main psychologically destabilizing force. Since the Islamic Republic is the world’s fourth largest crude oil producer (crude oil is used to make gasoline) at 2.3 million barrels a day, any perceived disruption in Iranian oil supplies would cause gasoline prices here at home to rise. It doesn’t matter that the US hasn’t imported a drop of Iranian oil since 1979; a cut off in supplies would destabilize the world market for oil, causing Iranian oil customers to seek supplies elsewhere, putting them in direct competition with the US.

Well, Iran announced last month that it would preempt a new European Union oil embargo on the country by cutting off all oil shipments to the continent immediately. The countries in the EU that currently import Iranian oil will now be left scrambling to secure supply, six months earlier than they had planned.

There is concern that this will cause a temporary disruption in oil flows, keeping some Iranian oil off the international markets. But while the Iranians say they have cut off supplies there is no evidence that they have done so. Nevertheless, the market is afraid that if they haven’t done so already, they will be cutting off some supply in the near future.

Ever since Iran said it was preempting the embargo, the two major world crude oil benchmark prices, West Texas Intermediate and Brent, have soared, pulling gasoline prices up in the process. The price of oil that refiners pay to make gasoline is linked to those benchmark prices, so higher crude prices get passed down to you.

The benchmark prices are set in New York and London where traders bet on the future price of oil and gasoline, taking either a long (bullish) positions or a short (bearish positions), by buying a futures contract. How traders bet has a big impact on what you pay at the pump. If a lot of traders believe oil and gasoline prices will go up in the future (due to an Iranian oil disruption or aliens eating Saudi Arabia, etc.), it tends to create an upward spiral in prices. That causes more traders to pile on the bullish trade, pushing up prices even higher. Eventually, though, market fundamental should pull those prices back down to earth, it just takes a while sometimes.

One way to see where oil and gasoline prices might be headed is to look at the number of outstanding futures contracts that are betting prices will rise versus those betting prices will fall. This data is found in a report published weekly by the Commodities Futures Trading Commission called the Commitment of Traders Report.

According to the most recent report, the number of long gasoline contracts (betting prices will rise) outnumber short contracts (betting prices will fall) is currently at an all-time high. The fact that the market is extremely net long gasoline explains, in part, why prices are high at the moment. The fact that it is at a record high suggests that there is some real fear in the market.

Now, if Iran truly did cut off oil supplies to the world or if Nigeria, a major oil exporter to the US, descended into a chaotic civil war, such a piling up on the long side of the trade would be totally understandable. But given that really nothing has happened to oil or gasoline supplies suggests that the market is really going

overboard. Traders call this an “overbought” market. Whenever the market pendulum swings hard one way (in this case toward the long side of the market), it usually will swing the other way – fast. Namely, if nothing comes of this Iranian oil mess soon enough, then there inevitably be a stampede for the exits, meaning that those traders who were long gasoline will try to cut their losses and close out their positions. This causes a downward spiral in prices, which leads to lower gasoline prices.

Now, the Iranian oil situation may be the main factor in the latest run up in oil and gasoline prices, but it isn’t the only one. There are some legitimate reasons why there should have been an uptick in  prices (like the changeover from cheaper winter gasoline to the more expensive summer gasoline blend) and others that would call for a downtick (like the fact gasoline demand in the US is down around 6% in the last four weeks). All these factors should be considered and weighed appropriately before you can know for certain where prices will end up. But for now, keep watching what the traders do – they usually lead this market roller coaster.

Cyrus Sanati is a frelance financial journalist whose work has appeared in dozens of leading publications, including The New York Times, BreakingViews.com, and WSJ.com. Follow Cyrus on Twitter @csanati.