Gas Prices Explained

Solving the deep mystery of gasoline price fluctuations

Good news for American drivers! Just in time for the Labor Day weekend, gasoline prices are falling. According to the Energy Information Administration (EIA) gas prices peaked in the spring. Gas prices usually rise in the spring because of the supply constraints created by the switchover to specially formulated summer gasoline mandated by the Environmental Protection Agency. The EIA reports that in May the average price for a gallon of regular got up to $2.87. Since then prices have been wiggling downward to around $2.65 per gallon today.

So what determines the price of gasoline? Speculators? Evil conspiring oil companies? Well, actually no. It's demand and supply, of course. On the demand side the American automobile fleet gets better gas mileage than it did a few years ago and Americans, whacked by the recession and high unemployment rates, are driving a bit less than they used to. In addition, thanks to government subsidies, about 9 percent of what goes into our gas tanks is ethanol produced from corn, which also reduces the demand for refined crude. On the supply side, global oil supplies are ample and refiners in the U.S. evidently believed the Obama administration's rosy "recovery summer" scenarios and stockpiled a lot of gasoline.

So what will happen to future gasoline prices? Let's review a little a bit of history. World oil prices peaked at about $147 per barrel in July 2008—the highest price ever for crude. Earlier, in May 2008, the investment bank Goldman Sachs issued a report suggesting that a "super spike" would push oil prices above $200 per barrel by 2010. That didn't happen. Oil prices began a steep decline as the global recession came on. By November 2008, Goldman Sachs had recanted its super spike projections and was predicting that oil could fall as low as $50 per barrel. Actually oil prices collapsed to just above $30 per barrel by December 2008.

In short: Gasoline prices follow the trajectory of oil prices (plus an additional premium due to fluctuating constraints on refining capacity). On July 14, 2008, the Energy Information Administration reported that gasoline prices in the U.S peaked at $4.05 per gallon, up from the low of just 88.5 cents in February 1999 ($1.15 in 2010 dollars). In inflation adjusted terms, the price of a gallon of gasoline in 1999 was the lowest ever in history. Why? Because the price of crude had also fallen below $10 per barrel, its lowest level in real dollars since the end of World War II.

When oil prices collapsed in 2008, the average price for a gallon of gasoline dropped to $1.59 in December, which is just about where it was in December 2004, when the price of petroleum then also hovered in the mid-30 dollar range. Since the crazy price swings of 2008, oil prices have rebounded to between $70 and $80 per barrel. Today, average gas prices are actually slightly below where they were when oil was at about the same price back in September 2007.

So what can American motorists expect for future gas prices? As we've seen it all depends on the price of oil. Earlier this year, the international insurance syndicate Lloyd's of London issued a rather bearish report [PDF] suggesting that "a spike in excess of $200 per barrel is not infeasible" around 2013. "An oil supply crunch in the medium term is likely to be due to a combination of insufficient investment in upstream oil and efficiency over the last two decades and rebounding demand following the global recession," states the report. "This would create a price spike prompting drastic national measures to cut oil dependency."

On the other hand, Cambridge Energy Research Associates (CERA), one of the world's leading oil supply consultancies, rejects the notion of imminent "peak oil" and projects a more bullish production increase from about 85 million barrels per day now to over 115 million barrels per day by 2030. Afterwards, the CERA analysts foresee global oil production reaching an "undulating plateau" lasting for several decades, perhaps until 2070, before it begins a permanent decline. In addition, the CERA report speculates that "peak demand" could happen before peak oil is ever reached. Demand for oil peaked in the developed countries in 2005 and the CERA analysis notes that over the next decades improvements in areas ranging from automobile engine technologies and the electric battery to changes in demographics and values could significantly lower the projected demand for oil.

The key variable to keep in mind when looking at future oil prices is how much spare production capacity is available globally. Spare capacity prevents and cushions price shocks. During the 2008 price run up, global spare oil production capacity fell to as low as 1 million barrels per day. According to CERA, current spare capacity is a comfortable 6.4 million barrels per day. However, like the Lloyd's analysis, the CERA report worries that persistent underinvestment in production combined with recovered global economic growth could lead to a tightening of supplies by the middle of this decade resulting in higher prices.

So there you have it, expert opinion suggests that oil prices, and thus gasoline prices, will fluctuate based on demand and supply. Now fill up your tank and drive somewhere to enjoy your Labor Day weekend.

Ronald Bailey is Reason's science correspondent. His book Liberation Biology: The Scientific and Moral Case for the Biotech Revolution is now available from Prometheus Books.