Lessons from the Gas Pump about Oil Price Volatility

As I filled the gas tank in my wife’s car this weekend I chuckled about the great low price I was paying for the experience. It made me feel so good I went inside the Chevron service station and bought a lottery ticket and a few scratchers for good measure. This was my lucky day.

Later, I asked my wife if she won anything on her scratchers—“Yes! She cheered $10 and a free ticket. Now where are you taking me for dinner.”

What does this have to do with oil price volatility?

Actually, I bet this same experience was repeated thousands of times in the market this past weekend. Maybe your scratcher proved to be a dud or maybe you got the winning Lotto ticket. Why? Because your state of mind changed from cussing out the gas pump because the high gasoline prices to a ‘feel good’ experience of savings money from the recent plunge in oil prices lower than expected are making their way to our gasoline price bottom line at the pump.

If you chuckled like I did at your good fortune and then impulsively spent your savings on lottery tickets. Then gave them to your wife who won $10 and a free ticket (you know you can never get just one ticket) and then had a wonderful dinner date with the one you love at a romantic location like In-n-Out Burger where you shelled out twice your scratcher winnings for the experience while feeling wonderful all around for the experience—Phew! Take a deep breadth. You have just participated in the common behavior economic impact of getting lucky—in the market!

If prices at the gas pump had gone up you’d be grumpy not only because prices were high but this gas tank is SO-O-O big and is going to cost so much. You’d fill the tank and go home. But with prices down 30% your savings are like found money. Did you save it? Of course not—you spent it on lottery tickets and started that money rippling through the economy. Then you multiplied it by cashing in your $10 scratcher and spending $25 to take your wife to In-n-Out Burger and then to B&R for ice cream after—you big spender.

Volatility is a Wonderful Thing

Especially when it is working in your favor by lowering prices—that brings me back to oil price volatility we are experiencing now. Lower oil prices have an uneven impact in the market but all the market participants are engaged in hedging their bets. I bet that lower prices would stay low for a while longer, at least, so I spent my gas pump savings on a wonderful time with the person I love. (Don’t tell her she’s part of my economics lesson or the implied value of my experience will crater like oil prices.)

The sum of millions of such experiences will test the market and competition will deliver a verdict—a demand signal which when compared with the supply signal will produce a market clearing price—ah, market equilibrium.

But having been burned by rising prices before, I’ve learned that what goes down will almost certainly go back up again. The key is having a strategy to manage uncertainty in the market.  A strategy is not the specific choice I make in any given transaction but whether I have a consistent method to assess market uncertainty and determine my course of action.  My decision in any one situation depends upon how my behavior and psychology shaped my attitude about price movements. But making a smart decision depends upon how I make it.

Here are some simple rules of thumb for managing uncertainty that have served me well:

1. Have a plan of action ready when price volatility happens. If you think gas prices will come down before you must refill the tank again you have an option to put a little less in the tank now in anticipation of future savings (backwardation). If you think gas prices will rise in the future you fill the tank now (Contango).
2. Develop a Consistent View of Markets and Prices. Gasoline prices are the sum of our fears about crude oil prices, refining costs, risk of supply disruption (Hey—this is California where we have boutique fuels only available in limited quantities to meet specific politically correct blends in specific regions. No imports or substitutions allowed. I need a reference price for gasoline to know when I get to the pump whether I am getting burned because the price never goes down as fast as it goes up.
3. Enhance Operational Visibility from the First Mile of the Value Chain to the Last. If I hear about a flash fire at a local refinery and my tank is low I go get gas before they can raise the price. In the oil and gas fields a version of this same game is played with chemical injections of methanol and corrosion inhibitor, for example, where timing, set points, injection rates and having a consistent point of price reference can save a producer perhaps 25 to 30% in OPEX for chemicals. That is serious money especially in a low priced oil & gas market environment.
4. Execute your plan well using value improving principles. So if the Richmond refinery has a fire taking the plant off line I get burned at the gas pump instantly!). Before I just pull up and fill up my plan is to check if there is a price spread bigger than usual between the price at Chevron and the price at Rotten Robbie gas station down the street—if yes guess who gets my business. For oil & gas producers simple value improving practices to gain better operational visibility of a well or field can often produce substantial cost savings and improve the ROI when the company needs it most. So get your act together people!
5. Beware of herd mentality. Volatility in markets creates opportunity not just for savings and value creation but also to make dumb decisions. This risk goes up when you don’t follow these first four steps and just go with the herd in the market. One risk in volatile markets is often called ‘catch the falling knife’ when you over do your hedge betting prices will move one direction only to find out too late that they moved the other direction. Speed in making decisions in response to changes in volatile markets is good but not if you are doing dumb things.

Volatility creates value as well as risk. If you develop a strategy to manage uncertainty and execute it consistently and well you are more likely than not going to find the value and avoid the nasty surprise at the pump.