Can Crude Oil Futures Predict Spot Retail Unleaded Gasoline Prices?

Article excerpt

Abstract

The motivation for this paper began with casual empiricism regarding the brief distributed lag of retail gasoline prices behind crude oil futures. We developed a model consistent with our hypothesis and tested it with econometrics using statistical data that include the sharp decrease in crude oil price futures in late summer 2008. We found that our model is a consistent and efficient estimator of the actual gasoline prices over most of our sample period. However, random shocks to gasoline prices, like Hurricane Ike in 2008, cause the model to have problems accurately predicting gas prices. We conclude that our estimated model and simulations provide reasonable support for our hypothesis that crude oil price futures can predict spot retail unleaded gasoline prices.

Introduction and Background

The motivation for this paper began with separate instances of casual empiricism by the two authors in the community where we live and work. One author made a habit of noting near-term futures prices of unleaded gasoline on the New York Mercantile Exchange (NYMEX), adding sixty cents to those prices, and being able to predict what discount retailers would charge for regular unleaded gasoline that week in our local markets.

The other co-author spent one and one-half years tracking crude oil futures prices on the NYMEX and their correlations with retail gasoline prices at a brand name outlet in our local market. This led to the creation of a formal model to forecast future changes in spot retail unleaded gasoline prices at the local outlet. This model can be expressed as follows:

E([G.sub.t+1]) - [G.sub.t] = [[G.sub.t]/[O.sub.t]]([O.sub.t] - [O.sub.t-l])

A numerical example illustrates this model. Assume that the retail unleaded gasoline price ([G.sub.t]) is $3.00, and the change in the futures price of crude oil ([O.sub.t]-[O.sub.t-1]) is a $1.00 increase to $80 in time period (t). The model predicts that spot unleaded gasoline will increase from $3.00 to $3.0375 in time period (t+l) which is one day later than (t).

While these casual empiricisms gave us a good indicator of where our research and model were headed, we decided it was necessary to expand our ideas and formulate a linear model from our additional findings. The first of these findings was the four major components of the price of a gallon of gasoline. These components are distribution and marketing, refining costs and profits, federal and state taxes, and crude oil (see Figure 1). We look at each of these four components as a percentage of the average retail price of a gallon of unleaded gasoline. As Figure 1 shows, the average retail price of a gallon of regular unleaded gasoline has increased 136% from January of 2000 to August of 2008. From the findings in Chouinard and Perloff (2002), we note that there is a consistent rise in the percentage that is related to crude oil prices relative to the price of gas. As the price of oil moved close to $145 a barrel in 2008, the crude oil price contributed 73% to the price of a gallon of gas compared to 46% in 2000 and 58% in 2007. This signals that there is a direct and persistent relationship between higher crude oil prices and higher retail gasoline prices.

Although refining costs have also increased during the last few years due to an increase in the cost of raw materials, as a percentage, these costs have been reduced over time. Over the last several years the tax rates on gasoline at the state and federal government levels have remained relatively unchanged, but the percentage of the cost from these taxes on retail gasoline prices has fallen as crude oil prices have risen. Distribution and marketing costs in dollar terms have risen due to the higher price of gasoline and increased expenditures by oil companies on ad campaigns in defense of an industry that was criticized as retail prices of their products increased. However, these costs over time have also decreased as a percentage of retail gasoline prices. …