Energy & Entrepreneurs #3                                                                                         

Gas Prices Down, Prices Up - Why?

by Raymond J. Keating

Why do gas prices go up and down? Since prices at the pump have climbed higher in recent months, individuals, families and small businesses are asking this burning question.

When it comes to energy, sometimes the answers verge on being quite ludicrous from an economics perspective.  One often hears speculation about grand conspiracies, market manipulation and political intrigue.  Yeah, right.

Fortunately, though, there are calm voices of reason out there who examine the real issues impacting markets and prices. For example, last month, the American Petroleum Institute released a report titled "What Goes Down Must Come Up: A Review of the Factors Behind Increasing Gasoline Prices, 1999-2006." It was researched and written by Dr. Carol Dahl, a professor of economics at the Colorado School of Mines.

The following points from Dahl are worth highlighting:

• "U.S. gasoline prices nearly tripled between January 1999 and July 2006." At the same time, after adjusting for inflation, "consumers enjoyed unusually low gasoline prices over a decade from 1986 to 1999," and "average gasoline prices in 2006 were lower than the average annual prices consumers paid in the period 1978 to 1982 and during the 1930s."
• "Historical analysis shows that changes in crude oil prices explain about 97 percent of the variation in the pre-tax price of gasoline between 1918 and 2006. Over that period, a $1 per barrel increase in the crude oil price consistently generated an increase in the gasoline price of about 2.5 cents. Between January 1999 and summer 2006, crude oil prices more than quadrupled from $15.50 per barrel to over $65 per barrel. Based on the historical pattern, gasoline prices would be expected to increase by more than $1.15 per gallon in the same period. The actual increase in gasoline prices was slightly lower than this forecast amount."
• "The changes in gasoline standards that have improved our environmental quality have also pushed up prices. The proliferation of ‘boutique fuels' has had the effect of reducing the capacity of the U.S. refining industry and increasing price volatility by limiting arbitrage opportunities. Between 1990 and 2006, the number of different grades of gasoline increased from three to fourteen. This trend made refining more complex, requiring refineries to reconfigure their operation at lower production levels or invest money to sustain the same output. This product proliferation also reduced the market's ability to mitigate temporary geographic shortages by diverting gasoline from other regions, since different regions may not use the same products."
• "The magnitude of refiner profits is often exaggerated. From 1977 to 2005, the rate of return on investment in U.S. gasoline refining averaged less than 7 percent. This compares unfavorably with returns over the same period of 9 percent in durable goods and over 11.5 percent for the S&P 500 industrials."
• "Environmental regulations may have had the effect of reducing capacity additions. To produce fuel that complies with new standards, refiners must often make substantial investments that do not increase total output. Uncertainty about future regulations may also depress investment as refiners delay expenditures until they can accurately forecast the mix of products they must produce."

Dahl also notes the link between rising U.S. income levels and increases in demand for gasoline.

None of us should be surprised by these explanations.  The price of oil, demand and a variety of measures influencing supply - including government regulation - all come into play regarding prices at the pump.  It's not a conspiracy. It's markets. Where our elected officials can make a difference is in advancing policies that expand opportunities for exploration, development and production to meet the economy's energy needs.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council