What's Up with Gas Prices?

You've seen the joke perhaps. A gas station owner in California has changed his posted prices: Regular costs an "Arm", Plus costs a "Leg", and Premium your "First Born". At least laughing is better than crying or screaming. The national average price of regular gasoline was $2.907 a gallon in May, according to the Department of Energy, a record for any monthly average and up 34.5% from a year ago. How did it get this bad? Can we do anything about it?

The answers begin in the economist's favorite phrase, "supply and demand". If the demand for a product increases, but the supply doesn't, the price will rise. But if suppliers increase supply to meet the larger demand, the price can stay the same. Thus, both supply and demand are involved in determining the behavior of prices. At a given moment, it's easy to forget one or the other of these counter-balancing forces, but they are both present and will make themselves felt.

Cheap Energy = Big Demand
So, for instance in the early 1970s, we were barreling along in big cars. A 1970 Buick belonging to a friend of mine was over 18 feet long and weighed 4,400 pounds; every car worth talking about had a V-8 engine. There weren't any mileage statistics, because no one had to keep them. And no kidding, the speed limit on the Kansas Turnpike was 80mph. Among households, it was said that social status in Houston was tied to how cold you could make your home in the summer. Factories belched out smoke, and while fuel cost mattered, it was no more important than any other business expense and was certainly not a constraint on the design of plants or equipment.

Supply Shock in 1973-74
Leaders of the Organization of Petroleum Exporting Countries (OPEC) knew, of course, that the US and other countries were using a lot of their oil, which they were selling us at about $3 a barrel. The price was trivial, and people were using a lot; perhaps it wouldn't make much difference if the price were higher. The OPEC officials, who basically controlled the world's oil supply, decided to find out. At the end of 1973, they stopped all shipments for three months and when they resumed, the price was about $10 a barrel, more than three times higher! (A barrel, the standard measure for crude oil, contains 42 gallons. The steel drums characteristic of Caribbean music are made from the tops of these barrels.)

What a shock! It did take a while for people to adjust to the new world of costly energy. OPEC was able to raise prices still more; in 1982, they topped out at about $38/barrel. In fact, it took three recessions in the US, including a severe one that lasted 18 months in 1981-82 and pushed the unemployment rate to 10.8%. But energy demand finally slowed enough to get prices back down and more under the consumers' control instead of producers'. Moreover, the demand lessons stayed with us. We redesigned cars, built new factories and retooled old ones; "climate control" became an engineering specialty. To illustrate, the current mid-level Buick sedan that might be comparable to my friend's 1970 model has a V-6 engine, is nearly 2 feet shorter and weighs 800 pounds less. With the reduced oil demand, prices slid back down. At the end of 1998, they touched $11 a barrel. Gasoline went for "just" 91 cents/gallon in February 1999.

Big Demand Redux
But this "cheap" oil spurred demand anew. While Americans tolerated "compact" cars, still deep in their hearts they loved big ones. Federal mileage standards effectively limited the size of cars that auto companies could sell. But there was a loophole in the regulations: they applied to cars, but not to trucks. Auto companies began to make mini-vans and SUVs. They are "trucks", but they're designed for family and suburban driving. The definition of "truck" is very liberal; even Chrysler's PT Cruiser is a truck. By Spring 2001, truck sales surpassed car sales. Trucks don't get very good mileage. Gasoline demand surged.

And prices went right back up – and up. We don't lay the blame for this price increase solely on American drivers, but they've certainly supported it. Against this backdrop of heavy gasoline usage, energy markets are vulnerable to other demand and supply forces. Demand around the world has increased significantly; in some fascinating patterns we will detail in a later article, many countries are participating, China and India, to be sure, but other places you might not think of, like Spain.

Supply Uncertain in 2006
Then there's the political risk. Just Sunday, Iran threatened to cut its oil exports as a tactic in the current controversy over its access to nuclear energy. This supply scare rattled markets, and the price of crude oil hit a three-week high Monday morning of $72.60. Other events all over the Middle East add to the uncertainty over supply.

Closer to home, there is the lingering supply constraint of last summer's hurricanes. Gulf Coast refineries have recovered some, but not all, of the Katrina-Rita-Wilma-related production losses; in March refinery output of gasoline in that region was still 9.3% below a year ago. Nationwide, gasoline demand rose 1.5% in the first quarter; for oil companies to meet that demand in the face of this lower refinery supply, they had to import more than usual, export less and cut their inventories.

At the same time, some demand and supply factors work the other way. High prices do restrain demand and that has already started to show up. Energy Department data available through March show that gasoline consumption, while a bit higher this March than a year ago, is below March 2004, which was evidently the peak period. Truck sales have also been falling and were down in May by nearly 10% from a year ago, as people have been shying away once again from gas guzzling vehicles.

Hope Through Hybrids
On the supply side, high prices and accompanying high profits elicit new products. This is perhaps the most overlooked development. More energy producers are inspired to reach for a piece of the action. Ethanol-blended fuel is becoming more widespread. Hybrid cars, once hardly more than a science experiment, are becoming more commercially viable. Windmills are making a comeback.

A highlight here is the dynamism of technology. You and I can be discouraged by the weight in our budgets of expensive gasoline and the high electric bills we'll have this summer as we run our air-conditioners. But just as computers have become more and more powerful, so can more economical ways to use fuel emerge. If it's a technology problem, science and industry can work on it. They're good at that. Effective supply will increase: that is, we'll find better ways to do as much or more with less energy than before. Don't short-change imagination.