Oil prices are subject to various economic and geopolitical shocks and are highly volatile. There are several factors dictating the price of crude depending upon where you are in the world. We’ll examine some of the main issues.
People are very sensitive to the level and changes in fuel prices. Hence, the authorities in every country are very careful with these prices as sudden large increases can create social unrest. They try to balance between the objective to collect revenue from fuel taxes and to fight pollution on the one hand and the objective to ensure that transportation costs do not hamper businesses and households on the other hand.
Governments in countries with large income inequality or high poverty rates try to keep fuel prices low and stable. The same applies to countries with large territories where transport is very important and to countries with large agricultural sectors as fuel is a major cost component.
The situation in most oil producing countries is a prime example. They subsidize domestic fuel prices as an important benefit to their populations. At the same time, their government budgets are heavily dependent on oil sales. A decrease in the price of oil can jeopardize their ability to provide cheap fuel and to tie up the government budget. In that situation, the country may be forced to raise fuel prices to compensate for the decline in budget revenue – a situation where fuel prices are increasing while crude oil prices are declining. It is important to keep such political economy considerations in mind when generating forecasts.
Marketing and Distribution Costs
The marketing and distribution costs can range from less than 10 percent of the final retail fuel price to well over 20 percent. The relative share of these costs depends on the market structure, the level of fuel taxes, and the cost of doing business in a country including the cost of land and labor. Also, those costs tend to rise over time with inflation which explains why countries have rising fuel prices over time even if crude oil prices and taxes are the same. A longer-term forecast has to account for the speed with which these costs rise in a country.
Seasonality is relevant mostly for short-term forecasts but should be mentioned because its effect could be substantial. The seasonal variations can sometimes exceed 10 percent of the average cost of fuel. In the Northern Hemisphere, diesel prices are typically higher during harvest time in the fall and during winter when diesel and diesel substitutes are used for heating. Gasoline prices are typically higher in the summer during the holiday travel months.
Oil is traded in U.S. dollars. When the currency of a country depreciates, this makes oil imports more expensive even if crude oil prices are unchanged. The reverse happens when the local currency appreciates: imported oil products become cheaper and fuel prices decrease. In fact, the effect on fuel prices of changes in crude oil prices and changes in exchange rates is the same. Whether Brent prices are 10 percent higher or the dollar is 10 percent more expensive is the same for countries that do not use the U.S. dollar as their currency. However, there is an important caveat. Exchange rates are much less volatile than crude oil prices and, in practical terms, the effect of oil prices is more important.
One more note should be made about oil exporting countries. When oil prices decline, their exports decrease and, unless they have a fixed exchange rate to the U.S. dollar, their currency depreciates. The depreciating currency puts upward pressure on all prices, including on fuel prices. Moreover, the government budget comes under pressure from the reduced oil revenue which limits the ability of the government to subsidize domestic fuel prices. As a result, we may have the curious situation where fuel prices are increasing while crude oil prices are declining.
Permanent vs Transitory Shocks and Speed of Adjustment
In countries with liberalized fuel markets, it takes about three to four weeks for fuel prices to adjust to a new level of crude oil prices as market participants continue to operate under the old contractual agreements for some time. The greatest impact is in week two.
Given that sluggish adjustment, if oil prices move in one direction and soon thereafter move in the other direction, we will see only oil price volatility and no change to fuel prices. The stability of fuel prices is even greater in countries with regulated fuel prices. Authorities typically wait for a few weeks to be sure that oil prices have experienced a relatively permanent shift before adjusting the fuel price levels. They are right to do so as oil prices often overshoot and the initial large movement is soon reversed either fully or partially. Therefore, a very short term forecast of fuel prices over a few days probably does not make much sense.
Petroleum prices are determined by market forces of supply and demand, not individual companies, and the price of crude oil is the primary determinant of the price we pay at the pump; that’s capitalism. But gasoline retailers are making greater profits when they raise the price of gas on the same inventory that’s in the ground. It seems more reasonable to adjust the price after each delivery of new inventory to justify profit margins.
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