Why do gas pump prices rise faster than costs?

John W. Schoen Senior Producer • Profile • E-mail

The continued surge in gasoline prices — and President Bush's speech this week offering relief — touched off a flood of mail from readers. Many, like Chad in Massachusetts, are having a hard time understanding why pump prices seem to have no relationship to the cost of producing the gas in the first place.

Why isn't there a law that states it is illegal to raise gas prices while X number of gallons of gas are still currently in the pumps? The gas that I am getting out of the pumps at a given station is the same gas that was put in there last week at a different cost. There is nothing that could happen to make those stations pay more for what they all ready have so why should I be paying more for it?
—Chad M., Easthampton, Mass.

Setting aside the problem of separating multiple deliveries sloshing around in an underground tank, the price at the pump is not determined by how much the retailer or wholesaler paid for the gas. The market price of any commodity is the price a willing buyer and a willing seller voluntarily agree to. You may be an extremely angry, frustrated, cash-strapped driver who needs to get to work, but you’re still a willing buyer when you pull up to the pump.

This is the part that many readers have trouble with: the market price of a given commodity has nothing to do with cost of producing it. If I want to buy an ounce of gold today, I’ll have to pay $650. That ounce of gold may have been mined yesterday, or a year ago, or 100 years ago — it doesn’t matter. If the market price of one ounce of gold goes to $650, so does the price of every ounce, even if it has been sitting in a vault since it was produced at a much lower cost.

A farmer can’t add up the cost of growing corn, tack on a 10 percent profit, and tell buyers, “This is what my corn costs.”  The market tells him, “This is what you’ll get for your corn.” In the days before farm subsidies, farming could be a terrible way to make a living. If a crop failed in a given year, the shortage would drive up prices but you might have little, if anything, to sell. If you brought in a bumper crop the next year, the glut would pull prices down sharply: You might have lots of corn, but you wouldn’t get much for it. Futures markets were developed to take some of that risk off the farmer's shoulders.

Today, farmers are guaranteed a minimum price because our government believes it’s in the nation’s best interest to keep U.S. farms in business and maintain our own food supplies. That and the ongoing efforts of a huge farm lobby that ensures Congress protects those subsidies.

In the case of oil, some buyers are end users, and others are speculators. Some sellers are companies that actually invested the money to hire a rig to go drill for the oil. Others are speculators who bought a futures contract — or even physical oil — betting that the market price would go higher and they would make money. True, when the market gets “nervous” it often adds a premium to a price that might not otherwise be there. The same is true on the flip side: when traders fear a glut, they may “oversell,” forcing prices lower than they might otherwise go. That’s what happened as recently as 1998 when oil prices crashed to $12 a barrel.

Without a global futures market, you would see even bigger, more frequent price spikes and crashes. Companies couldn’t protect themselves from higher prices by locking in delivery well into the future. Producers couldn’t invest in expanding production with any confidence they’d get back that investment.

History is littered with painful commodity booms and busts that happened before modern futures markets were set up. So the “premium” we all pay to the investors who buy and sell purely for profit is the cost of the market mechanism that brings some order to pricing. It’s money well spent.

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