An Economist Explains The Price Of Gasoline

(Original Caption) 1929- Portrait of John Maynard Keynes, who was an English economist.

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No, not me. (More later.) There is a huge debate now amongst market watchers between those who note that crude oil prices (until this week) had declined to near pre-war levels and those who argue that the market fundamentals plus the geopolitical risk should support much higher prices, over $100 a barrel even. The public would be forgiven for being confused and/or skeptical about what is happening to prices and our ability to explain it.

This is a real problem that economists often struggle with, given that many of their predictions have subsequently not proved out. As Greg Mankiw a Harvard economist once said, “We’ve always been bad at forecasting. Does that hurt our credibility? Probably.” (This quote from Prophecy by Carrissa Veliz, p. 67) One could defend economists by noting that politicians also often make predictions that don’t prove out, including about the current state of the Iran War and its impact on prices, but politicians don’t claim to be scientific.

Part of the problem stems from the apparent illogical behavior of prices. Once on a radio talk show, a caller asked me why different gasoline stations charged different prices, while another asked why different stations charged the same price. I hemmed and hawed through the answers but the point is that people perceive prices as set by humans, often a specific human, since they can see a gasoline station changing prices.

Which takes us to philosopher David Hume who noted, “…that nothing exists without a cause of its existence…” and referring to chance he believed was a way to conceal the cause. (Also from Veliz, p. 108) Substitute Adam Smith’s ‘invisible hand of the market’ for chance and you have what many economists retreat to as the deus ex machina, a copout that explains price movements as being imposed by outside, often opaque, forces.

So, what moves gasoline prices? It is true that a station owner notices the price at other stations and has to choose whether to match it, go above it and lose business or undercut it and gain sales but at the expense of profit. However, a step before that is the wholesale price the station owner pays; most stations will face the same wholesale price, which is why prices rarely diverge significantly from station to station. That said, different locations can mean much different costs; land costs near a highway are usually far above those in a rural area. Delivery costs depend on how close a station is to the wholesaler and whether supplies are trucked long distances.

But the wholesale price neither exists in a vacuum nor is set by a specific person. Rather, wholesales buyer from refiners and the limited number of refiners means that they are often price-takers, paying what the refiners set with few options. It might seem that the refiners’ prices would be set by crude oil prices and the cost of refining, but in reality they are set by the spot market price of a product. If you undersell that price, your sales will soar until you sell out and you will lose money on every gallon; price above the spot level and your customers will go elsewhere.

So, where does the spot price for gasoline come from? This is where the not-so-invisible hand of the market comes in. Decades ago, the spot price was determined by traders in the major markets: the U.S. Gulf Coast, Rotterdam and Singapore especially. Prices would move up or down to balance the market; nobody’s buying, price goes down, nobody’s selling, price goes up. Similar to a classic New Yorker cartoon where the anchor says the market went down because no one wanted to buy. (Yes, that is simplistic.)

Of course, more is involved than just the observed supply and demand for gasoline in a trading center, also known as the fundamentals. Expectations play a major role, including expectations of the fundamentals—is the summer driving season approaching, will a local refinery enter maintenance—as well as less tangible factors–could war break out in the Middle East and so forth. So, the physical balance—fundamentals—are also influenced by intangibles—expectations and perceptions.

This has become closer to the invisible hand, especially now when those trades are frequently done online and buyers and sellers are not as visible. But ultimately, those online trades often originate in the trading centers such as the NYMEX where traditionally traders shouted out orders to buy and sell, reacting to who around them was buying or selling. The classic comedy “Trading Places” depicts this very well, including the way traders react to what they think other traders are thinking and doing.

This is where markets can seem to diverge from reality: violence in Israel might have not major impact on the market, but traders know that other traders are watching and reacting to news as it comes in. A terrorist attack in Israel might have nothing to do with the oil market, but traders fear others will react and so they do as well. These types of factors usually do not have a persistent impact on the market, but on an hourly, even daily basis they can move prices up or down, sometimes sharply.

At present, it seems as if traders in the paper markets are reacting in part to the current market balance, expectations for the global economy and demand, and geopolitical concerns, from threats to supply to the chances of a ceasefire which would be uncertain duration. And while there are numerous pundits weighing in on the Middle East political situation, with pretty much every possibility short of alien invasion being considered by someone, there are also many views on the fundamentals.

This is because unlike ‘just-in-time’ inventory systems, the global oil market is translucent. Satellite imagery does provide much better information about global oil inventories than in the past, but demand and supply estimates continue to be driven by a mix of analysis and guesswork. The EIA, IEA and OPEC along with numerous consulting firms all produce detailed forecasts of the market balance a year or more into the future, but those are suggestive not definitive. Traders react to new releases of these reports because they know other traders will do so, no because they consider them definitive.

A quarter-century ago, I produced a report called “Drivers of Oil Price Volatility” for the International Energy Forum 2002 Osaka meeting, subsequently published here: https://www.jstor.org/stable/24808868. It quantified some of the uncertainties about both data on the current market and the short-term forecasts. The figure below is an updated graph, showing what the IEA calls “Miscellaneous to balance,” meaning the discrepancy between global supply, demand and inventory change. Essentially, in July 2026, they were unable to account for approximately 1.2 mb/d of oil in the second quarter of 2025. That’s seemingly a lot until you realize it is less than 1% of oil demand. Still to paraphrase Everett Dirksen, a million barrels a day here, a million barrels a day there, pretty soon you’re talking real money.

As you would expect, the forecasts are much more volatile and uncertain. In theory, predicting global oil demand should be much more straightforward than prices or supply, but the figure below shows the quarter-to-quarter change in global oil demand based on the current monthly reports from the EIA, the IEA and OPEC. (OPEC’s report doesn’t include data for 2025, I have used an earlier report.) Expectations vary by as much as 2 mb/d especially in the current disrupted market. And again, traders don’t just react to changes in the published forecasts but the fact that other traders will respond to them, even if they don’t consider them credible.

Which brings us to the economist explaining gasoine prices. John Maynard Keynes famously made a fortune on the stock market, but prior to that, he twice lost a fortune but in the best academic tradition (or it should be), he recognized the shortcoming of his strategy and adapted it, ending a wealthy man. The lesson: economics don’t determine an asset’s price, the traders’ perception of the economics do. And the current market is teaching us that perceptions can vary quite a bit.