As a professional energy economist I am obligated to set the record on gas prices straight. This week I’ve heard that President Obama is to blame for higher gasoline prices. I have heard politicians claim they can lower gasoline prices. A noted MSNBC announcer that covers the stock market pronounced that removing oil industry subsidies would raise gasoline prices.
Here’s the economic truth:
TRUTH: Price = Supply and Demand
Gasoline stations adding a mark up to supply costs do NOT set prices. Prices are established by the market dynamic of consumer demand and manufacturing supply. The price of oil is high right now because incremental world demand is growing faster than the marginal capacity for increasing oil supplies.
TRUTH: Gasoline prices will NOT come down
Because it is supply and demand that sets the price of gasoline, the price of gasoline will not fall over the long term. Does anyone really think the price of gasoline will be less in 5 years?
There are two mega-trend reasons why the long term price for gasoline will be higher:
The first is that there are no more “Saudi Arabias.” That means the world no longer has an easy-to-recover, low cost, low risk new pool of oil to harvest. There is still a lot of oil to be recovered but it costs more to do so because of very high risks and costs tied to geopolitical issues and the high potential for causing environmental damage associated with new deposits of oil. The only scenarios where pump prices could fall are a global economic collapse or breakthroughs in biofuel technologies.
The second more telling reason why prices will rise over the long term is that world demand for oil is growing faster than incremental new supplies can be delivered. The world is adding a new middle class over the next 20 years that will have a buying power equal to 1.5 times the current U.S. annual Gross Domestic Production. In economics this is called the “Income Effect.” This new middle class is expected to buy more oil even at higher prices because their incomes are higher.
FALSE: “Drill Baby Drill” will lower pump prices
I know of no oil industry executive who thinks there is so much lower cost, lower risk oil still to be discovered that it will lower the price of oil in the face of the world’s growing incomes and the use of this income to buy more gasoline, diesel, plastic bags, fertilizer, etc. More supply may reduce the pace of price increases. It will not lower prices.
FALSE: Government oil production subsidies keep gasoline prices lower
The incentive to find more oil is tied to how much money an oil supplier can make selling their oil. The value of an oil company’s stock is based upon how much oil it has in reserves, its ability to find more oil and the market price of oil. Government subsidies are much too low compared to today’s overall value creation realized from finding commercially deliverable oil for their removal (or increase) to impact the incentive for oil companies to find and deliver more oil.
What has changed in the oil & gas industry’s pursuit of oil is oil’s higher price. At today’s price we are seeing an explosion in hydraulic fracking drilling for gas (and the refining of Canadian oil sands). Fracking is not a new technology though there have been, and continue to be, technology improvements. What is new is the higher price of oil that makes this technology economically attractive for finding more oil and natural gas. Proof of point is the current $2.50-2.75 price range per MMBTU for natural gas that is 50 percent lower than just a couple of years ago. This lower price was realized by the increased commercial use of hydraulic fracking that has generated such an abundance of supply that natural gas suppliers are now curtailing production to support natural gas prices from falling further. Why oil is not seeing a similar price decline, is because the world demand for oil is so strong compared to incremental supply capacity plus the geopolitical risk of the curtailment of current supplies.
FALSE: Politicians can lower gasoline prices
That is only partially true. There is a lot of tax placed on gasoline at the pump. So politicians could eliminate this tax and the price at the pump would be less until this lower price sparked increased consumer demand against a static supply. The ultimate result will be the price of gasoline pushing back up at the pump.
The real price responsibility of the political system is to reflect a true cost at the pump (or meter and cash register) that includes social and environmental externality costs. The current political system includes the military cost of protecting oil supplies as a part of income taxes. Why? Economic efficiency (this is a term used by economist to describe when consumers make informed decisions) is gained if this cost is reflected at the pump. This same economic sense applies to the health cost impacts of gasoline and diesel tailpipe emissions (and the stacks at coal fired power plants). Currently these are reflected in health care premiums and Medicare taxes. What politicians should do is shift the societal and health cost impacts of burning fossil fuels from income taxes to the pump (and meter) thus enabling consumers to make better informed decisions for the economy and their health by revealing the comparative value of options like hybrid cars, electric cars, mass transit, living near work, bicycling paths, solar supplied recharging stations, cloud based retail shopping, etc.
FALSE: High gasoline prices damage the economy
Read this twice: The U.S. economy is growing with a decline in gasoline consumption.
Gasoline consumption is down almost 3 percent compared to last year. The U.S. economy is growing at an approximately 2+% annual rate.
Gasoline consumption is at a nine-year low. A major reason is that new car fleet mileage is up 14 percent in just four years. (Yes, there is a spike in consumption this week. The reason appears to be consumers attempting to beat future price increases by topping off their gasoline tanks.)
Over the short term, because America still has a huge inventory of low MPG gasoline-powered cars, higher gasoline prices will have a negative impact upon economic growth because consumers will have less money to spend on other products that can generate jobs and economic growth. The key point is this is short term.
In fact the U.S. economy is rebounding as consumers and businesses adopt sustainable economic decisions. They are buying more energy efficient cars and trucks. The Millennial Generation is shifting from their parents’ suburban lifestyles to living closer to their work. With manufacturing economics of scale the per unit cost of cleaner technology cars and trucks is gaining retail price competitiveness. That is the foundation of my projection that in 2011 a world economy of sustainable goods and services achieved a $1 Trillion annual revenue tipping point. Further, we forecast that by 2010 the global annual revenues of sustainable goods and services will reach $10 trillion representing 20 percent of the world’s annual commerce.
The final pump price truths are:
1) Gasoline is a 20th century solution that is losing its price competitiveness to energy efficiency and cleaner technology solutions.
2) No politician can lower the world price of oil.
3) Oil companies are not creating higher oil prices. Believe me, at today’s prices they are trying as hard as they can to find more oil. And they are very concerned that higher gasoline prices will permanently erode U.S. demand for oil. But oil prices will not fall over the long term because the ability of oil companies to increase supply lags the incremental increases in the world’s consumer demand.
4) High long-term oil and gasoline prices are not a product of speculative trading. Corrupt trading could cause price volatility and spikes. But the underlying cause for higher prices is that incremental demand is growing faster than the marginal capacity of production.
As painful as pump prices are this is great news over the long term for America, the environment and our economy. Price competitive sustainable product solutions are emerging. The ramification of sustainable products gaining price parity is that 85 percent of consumers will buy the more sustainable product vs. the less sustainable product if their prices are equal. Counter-intuitively, today’s higher price for gasoline is accelerating our economy’s potential for implementing sustainable solutions that will create American manufacturing jobs and restore our environment.
Bill Roth is the founder of Earth 2017. His book, The Secret Green Sauce, profiles case studies of business best practices for making money going green. As the Green Business Coach for the U.S. Hispanic Chamber of Commerce Foundation’s Green Builds Business program sponsored by Walmart Bill has coached hundreds of business owners on best practices that make money and a difference.