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Whither Gasoline Prices?

Prices up, poll numbers down, round up the usual suspects!

Ronald Bailey
April 26, 2011

Gasoline prices are up to $3.88 per gallon on average in the United States because the price of crude is running at around $112 per barrel on the New York Mercantile Exchange. It’s really simple; the price of oil goes up, then so too does the price of gasoline.

In the face of falling poll numbers, President Barack Obama has ordered his minions in the executive branch to “round up the usual suspects” to investigate oil and gas markets for evidence of fraud or illegal manipulation in pushing pump prices up. It’s sad to see the man who promised “hope and change” engaging in the same cynical political posturing as his predecessors. For example, back in 2006, the Federal Trade Commission investigated gas price increases in the wake of the Hurricane Katrina disaster and uncovered no evidence of wrongdoing by oil and pipeline companies or refiners. Bold prediction: The Obama administration’s new investigation will also be unable to find any substantial amount of oil market misbehavior.

Of course, explaining that gasoline prices are going up because of oil prices leaves unanswered the question: Why are oil prices going up? Let's turn to some experts. Oil market analyst Timothy Evans at the Citigroup Future Perspectives notes that the Libyan civil war has taken petroleum production of about 1.4 million barrels per day off the market, about 1.6 percent of global supply. Even so, he observes that spare global capacity for oil production hovers around 4 million barrels per day. Compare this to 2008 when the price of crude spiked to $147 per barrel, global spare capacity was down to just 1 million barrels per day. 

Could low inventories account for the current run up in prices? Evans discounts this and points out that as of mid-April total U.S. petroleum inventories were at 54 days of supply. That was two days lower than last year at the same time, but three days above the five-year average. During the 2008 spike, U.S. inventories had fallen to 46 days of supply. Are U.S. consumers and businesses demanding more oil? Actually, no. Americans are burning 9 percent less oil than they did at peak usage in 2007. But surely global demand must be driving the price? Think of all the new cars in China!

Evans notes that, as one would expect, the economic recovery last year boosted global oil demand, which grew by 2.8 percent. However, he projects that global demand for this year should rise by about 1.7 percent. This is by no means an extraordinary increase. It is in line with recent history which saw demand rise an average of about 1.7 percent per year between 1993 and 2007.

So if there is adequate spare capacity, inventories are fine, and global demand is not extraordinary, where else might President Obama look for an explanation for pain at the pump and in his poll numbers?

Evans wryly points out that the situation in the Middle East has been a “bit unsettled” of late. Remember Libya? In early January, the price of oil was $82 per barrel; it sells for $112 per barrel today. “Primarily what we are seeing is a geopolitical risk premium being added onto the price of petroleum,” explains Evans. 

Market players are worried that further unrest in the Middle East and North Africa could result in greater supply disruptions. Evans mentions one dire scenario in which Saudi Arabia and Iran engage in the struggle for power in Bahrain between the ruling Sunnis and the Shi’ite majority. This could put shipments from the entire Persian Gulf region at risk. “The $112 price is basically a compromise,” says Evans. “Market players are betting that there is a 50 percent chance the price will fall back to $82 and 50 percent chance that it will spike up to $140 per barrel.”

Michael Lynch, an oil market analyst at the consultancy Strategic Energy and Economic Research, agrees that political unrest in major oil producing countries accounts for a lot of the recent oil price rise. Lynch, however, also thinks that the U.S. Federal Reserve bears some responsibility. Lynch argues that the price of oil was about $65 per barrel before the Fed began its program of “quantitative easing,” in which the central bank basically printed more money in an effort to shore up the economy. Lynch asserts that this Fed policy is “inflating a lot of assets like commodities including oil.” He attributes $20 of the recent petroleum price increase to inflating the money supply and $25 as a geopolitical risk premium.

On the other hand, Evans doesn’t think that Fed monetary policy has contributed that much to higher crude prices. Since March 2009 when the stock market hit rock bottom, Lynch notes that the major currencies dollar index has fallen by about 17 percent. The price of oil recovered as the global financial crisis waned and averaged $71 per barrel in 2010. A 17 percent decline in the value of the dollar would roughly boost the price of oil to $83 per barrel by itself, which is about where it stood at the beginning of January. In fact, there has been a 60 percent increase over the 2010 average price.

But what about those pesky speculators? Evans notes that since 2003 the number of futures and options contracts in the oil market have increased by more than 400 percent while the physical oil market has increased just 8.5 percent. “That tells me that futures and options trading is playing a larger role in setting the physical price,” says Evans. On the other hand, Evans suggests that the futures market may be “warning us that things are going to get a lot worse than we expect” with regard to supply disruptions emanating from the current unrest. 

Assuming the turmoil in the Middle East and North Africa begins to abate, what can drivers expect to be paying at the pump later in the year? Both Evans and Michaels think that oil would drop back to $80 per barrel, which implies a gasoline price of about $3 per gallon. What about future oil production? Evans dismisses peak oil as a “religion.”

Both Evans and Lynch point out that despite a deepwater drilling moratorium, U.S. domestic oil production has increased by 300,000 barrels per day since 2005. In addition, they argue that the underreported story is how much additional oil is coming online from smaller producers around the world, including Colombia, Oman, Uganda, and Sierra Leone. While both Evans and Lynch acknowledge that oil markets experience big price swings, they believe that oil will settle for the foreseeable future at around $80 to $85 per barrel. From their point of view, this price encourages adequate investment in exploration and production, while not dramatically discouraging consumption.

A final note: When contemplating the future of oil prices, one should always keep in mind U.S. foreign service officer James Akins’ observation, “Oil experts, economists, and government officials who have attempted in recent years to predict the future demand and the prices of oil have had only marginally better success than those who foretell the advent of earthquakes or the second coming of the Messiah.” Akins wrote that in 1973.

Science Correspondent Ronald Bailey is author of Liberation Biology: The Scientific and Moral Case for the Biotech Revolution (Prometheus Books). This column first appeared at Reason.com.


Ronald Bailey is Science Correspondent


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