Monday, June 06, 2005

Why Gasoline Prices are Falling - Somewhat

You may have noticed that gasoline prices have been falling noticeably in recent days. The reason for this drop is due to the change in seasons. During the warm summer months people tend to drive and travel more than during the winter. Also, during the warm summer months there is very little demand for heating oil. Thus, at this time of year, oil refineries reduce production of heating oil and increase the production of gasoline. This increase in the supply of gasoline, ceteris paribus, leads to a drop in its price.

Oil, like any other raw material that is extracted from the ground, is of no use to consumers. Only after the crude oil has been transformed (through the refining process) does it become a good that consumers can use. Oil refineries can convert crude oil into a number of different petroleum products but, for our purposes here, we will discuss just two – gasoline and heating oil. These are the two products that consumers directly consume most frequently.

During the winter months the demand for heating oil increases sharply as consumers in cold northern climates use it to heat their homes. At the same time, the cold, ice and snow make driving more difficult so people tend to travel less which leads to a reduction in the demand for gasoline. Therefore, during the winter oil refineries devote more capacity to the production of heating oil and less to gasoline. This can be illustrated by the production possibilities curve depicted below.

An oil refinery is limited by its size, number of workers, etc. as to how much crude oil it can refine per day/week/month. Given that the refinery is physically capable of refining only so much crude oil in a given period the owners of the refinery are forced to choose between producing gasoline or heating oil. They can produce both but to increase the production of heating oil in the period they must reduce the amount of gasoline produced and vice versa. This illustrates the concept behind the production possibilities curve perfectly.

How do owners of refineries decide how much of each product to produce? The answer is simple – their customers, the consumers tell them. As winter approaches people drive less – the roads are not as good due to winter conditions and, with children in school, people with children tend to reduce their leisure travel. The result is a reduction in the demand for gasoline which, ceteris paribus, leads to a fall in price. At the same time, the cold weather forces people to turn up the heat in their homes which results in an increase in demand for heating oil and a corresponding increase in the price of heating oil. Owners and managers of oil refineries respond by producing less of the lower priced gasoline and more of the higher priced heating oil.