Why Are Gas Prices Going Up When Demand Is Going Down?

The price of crude oil—and more importantly, gasoline—has climbed to painful levels once again. As of early April, the quote for Brent crude, the international yardstick, was about $126 per barrel—only some $16 below the $142 peak seen in the summer of 2008. But domestic West Texas Intermediate crude is only getting $107 per barrel—a full $38 below the 2008 peak. Meanwhile, we are told that U.S. oil production is up, gasoline demand is down, and we are even exporting gasoline to foreign countries. So why is the price of gasoline, at an average of $3.84 per gallon for regular, according to the U.S. Energy Information Administration, within five percent of the 2008 peak when domestic crude is fully 26 percent lower?

It’s easy to imagine oil-company conspiracies when seeing these figures. But, as usual, the truth is a bit more complicated—and less satisfying. As the chart below shows, the price of gasoline does move in concert with crude-oil prices, although the proportionality between the two does vary with market conditions. According to John C. Felmy, the chief economist for the American Petroleum Institute, since 1968, the retail price of gasoline has averaged about $1.17 above the price of a gallon of crude oil (in 2012 dollars). That figure includes the average state and federal taxes of about 49 cents (varying from 26 cents in Alaska to 67 cents in California, Connecticut, and New York), the cost of refining the crude into gasoline, the transportation and distribution costs, and the refiner’s profit.

By that standard, a refiner that starts with Brent crude pays $126 for a 42-gallon barrel of oil, or $3.00 per gallon, would be charging about $4.17 a gallon for gasoline. Refiners using WTI crude would charge $3.72. In America, most refiners are stuck paying the Brent price, because the WTI crude tends to pile up in Cushing, Oklahoma, and is only conveniently available for refineries in the Midwest. But if you blend these prices in a ratio of three parts Brent to one part WTI, you get an average projected retail price of $4.06 per gallon. Since gas is selling for about 20 cents less than that, the current price does not suggest price gouging.

As an aside, during the huge run-up in the summer of 2008, the gap between the price of crude and the $4.05-per-gallon retail price was only 60 to 70 cents, suggesting that despite the record gas prices, there was no profit being made in the refining business. That said, companies in the crude-oil drilling and delivery end of the business made a killing.

The current low margins in the gasoline business reflect soft demand for the product in America. As of early 2012, we are burning about 8.4 million barrels of gasoline per day (assuming 42 gallons per barrel, that’s about 14.7 million gallons per hour, or 4083 gallons per second). As staggering as that quantity is, it’s about 13 percent less than the 9.7 million barrels per day we consumed at the absolute peak in July 2007. Part of the reason is a reduction in driving. As a nation, we drove a peak of 3030 billion miles in 2007 and only about 2963 billion last year.

That’s about 2.2 percent fewer miles, and we’re also driving those miles in more efficient cars and trucks. According to a study at the University of Michigan Transportation Research Institute, the cars and trucks sold this year will average about 28.5 mpg by the federal Corporate Average Fuel Economy (CAFE) standards. That’s up from less than 25 mpg in 2007 and reflects both a shift from trucks to cars and the introduction of efficient technologies, as well as a greater preference for smaller vehicles.

Low American demand would suggest a lower price, according to classical economic theory. But both crude oil and gasoline sell on world markets, and global demand is on the rise (see chart below). From a low of 85 million barrels per day during the recession in 2009, current global usage is running around 89 million barrels. That exceeds the previous global peak of 86 million barrels in 2007.

This hearty appetite for oil includes all of its products, which is one reason why America is exporting a small fraction of its refined gasoline. American refiners can make a better profit selling gasoline overseas than they can in America because, “There isn’t a lot of excess capacity around the world,” according to the API’s Felmy. And just like wheat farmers or airplane manufacturers, oil refiners sell their products to whoever is willing to pay the highest price.

This demand for oil among the world’s growing economies—China, India, Brazil—has been running up against limited supplies, which is one reason that crude oil prices are rising. Another price driver is the fear that the growing tension with Iran over nuclear weapons development might either disrupt that country’s oil exports—the fourth largest in the world—or motivate the Mullahs in charge to mine the Straits of Hormuz and disrupt about 20 percent of the world’s oil supply.

Even as oil gets more expensive, the Chinese can afford to buy it because their economy is robust and their currency is getting stronger. Back in 2008, when Brent crude was priced at $142, it took 993 Chinese Yuan to buy a barrel. Today, if crude hits the same level in dollars, the Chinese will only need to spend 894 of their stronger Yuan for a barrel.

For the Europeans, it has gone the other way, thanks to their financial crisis. Not only do European motorists pay very high gas taxes, but as the Euro has declined, European gas prices have escalated even faster than in America. When oil cost $142 at the peak, that translated to €99. They’re paying almost that many euros to buy a barrel of today’s $125 crude, which is why gasoline is back up to $9 a gallon in some European countries.

There aren’t many signs of relief going forward. In the short term, gas prices usually increase with the transition from winter to summer fuel and the start of the summer driving season. Moreover, in July, Sunoco plans to close a key refinery near Philadelphia that currently provides about one fourth of refined products on the East Coast. This development is unlikely to do anything to reduce gasoline prices.

In the longer term, while the Chinese economy is slowing, that country’s economic growth—and demand for energy—will continue to increase to the tune of about 7.5 percent annually through at least 2030. To a greater or lesser degree, the same goes for India, Brazil, and several other fast-growing economies. As a result, even though America, Europe, and Japan are taking measures to use fuel more efficiently, global petroleum demand is expected to reach at least 105 million barrels a day by 2030—18 percent higher than today’s rate.

While the world is hardly going to run out of oil in the near future, much of the easy oil—the kind that simply gushes from the ground—has been harvested and future supplies will be harder to access and require greater investment. Think deep water and deep wells. Even so, oil’s high energy density and liquid convenience will continue to make it the fuel of choice for anything that moves.

All of this means upward pressure on oil and gasoline prices in the future. Prices will undoubtedly fluctuate, but the trend line is not likely to turn downwards. For now, only biofuels provide any meaningful competition and they will become more economically viable as gasoline prices increase. Meanwhile, if you’re in the market for a new vehicle, keep fuel efficiency in mind—or at least avoid a long lease.

Car and Driver