The Hidden Costs of Oil Price Volatility

As recently as a few months ago, an eerie calm had settled over oil markets. Volatility, fluctuations in the price of oil, had dropped to its lowest point since the 1990s, and was remaining low. Prices were moving roughly 3 percent or less each month, and analysts hailed a new era of oil price stability. Those days are over. Oil prices have slipped outside of the narrow band that satisfied producers without overwhelming consumers, and current price volatility is as high as it was during the aftermath of the global financial crisis. As Michael Levi and Robert McNally wrote recently in Foreign Affairs, “The return to volatility poses an immediate risk to the global economy. It is volatility, rather than high prices, that endangers global economic growth; right now, for example, falling prices are a positive, as consumers with more money in their pockets can buy more and stimulate the economy. But with Saudi Arabia and OPEC less able or willing to moderate oil prices, consumers can expect more price spikes alongside sharp price declines. Volatility also scares investors and consumers, deterring them from investing in oil infrastructure and from buying more efficient cars and trucks. Policymakers should therefore not view falling prices only as a sign of relief, but also as an indicator of trouble.” Most economist understand and believe that price volatility is inherently damaging for a number of reasons. Among them is the fact that high prices will inevitably return, and will catch the economy “off guard” once again. This is evidenced by the fact that American consumers are shifting attention away from fuel efficient and alternative vehicles, and back towards SUVs and other light trucks. Another problem is that when oil prices decline, some of the economic consequences of high prices remain and become entrenched in the economy. The most obvious instance of this is what economists call the “rockets and feathers” phenomenon between oil and gasoline prices, to describe how the two prices do not move symmetrically. Instead, observers note that gasoline prices will rise quickly when oil prices jump (shooting up like a rocket), but when oil prices fall, gasoline prices are slow to decline (drifting downward like a feather). A recent report by the Federal Reserve Bank of St. Louis uses the following language to describe this phenomenon: “The speed at which gas prices change differs depending on whether the price of gasoline is relatively high or relatively low compared with the price of oil. Both casual and industry observers say that gas prices adjust to changes in oil prices faster when gasoline prices are relatively low compared with oil than when gasoline prices are relatively high compared with oil. This uneven pass-through can be seen when oil prices rise after being steady for some time—gasoline prices shoot up quickly. In contrast, when oil prices fall after being steady for some time, gasoline prices retreat slowly.” The main explanation for this phenomenon is seller market power. When oil prices rise, gasoline vendors increase prices to maintain a constant margin, but when prices fall, retailers have little incentive to adjust prices downward by the same level, since customers are already accustomed to higher prices. This impact is more pronounced in areas of lower market concentration—gas stations that are further away from other stations are able to keep prices higher, since there is less competition and fewer points of reference for customers. Fascinatingly, this effect is not limited to retail gasoline, but also to the industries that rely on significant amounts of petroleum products—and there are many of them. One strong example is the airline industry. Many have noticed that even though fuel costs are way down, airlines aren’t passing on the savings to consumers. There’s further evidence of this impact on an anecdotal scale. As recently reported in the National Journal, many small business owners raised prices to accommodate the higher burden of gas prices. Prices have dropped, but they aren’t confident enough that gas prices will stay low to decrease their rates. From the Journal: “When gas was up around $5, it was killing us,” said David Grant, 50, of Fairfax, who owns a regional pest management company and spends several thousand monthly in fuel for his fleet of Ford F-150s. “I went ahead and raised my prices on everybody else.” This time, Grant said, he’s not lowering those prices, nor is he immediately reinvesting the savings. “It’s not enough yet to make some huge difference,” he said. We can safely expect that this effect reverberates throughout the economy: in everything from food prices to construction costs. Consumers should savor the savings at the pump where they can—they’re unlikely to last, and thus unlikely to be seen elsewhere.