Gas Prices—No Villains, Just Economics

Consumers are naturally upset by the doubling of gas prices over the last two years--the fourth major run-up in prices in the last four decades, following those of 1973-74, 1979-80, and 2007-08. I lived through all of them, and, as a CIA economic analyst, contributed to the Agency’s assessment of the 1973-74 increase (when US gas prices also roughly doubled, to about $0.80 a gallon). People tend to look for villains, and they usually blame the oil companies or politicians—especially the president—while politicians generally point to speculators or “price-gouging” by big oil. But speculators, at most, can only push up prices briefly and oil companies--if they really had the power to set prices--would surely raise them in small increments rather than with big jumps that draw lots of bad press. (If they had raised gas prices by, say, one cent per month, starting in 1973, the price now would be over $5 per gallon and probably no one would have noticed--Europeans have paid far higher prices for years.)

The good news is that prices usually fall back after the big run-ups, so some relief may be coming. The bad news is that there will be more price spikes in the future and that, on average, the cost of oil and gas will rise faster than prices in general.

Oil is prone to big price swings because neither supply nor demand can adjust quickly, so even a small disruption can have a big impact on price. Increasing supply requires years of exploration and development (unless Saudi Arabia uses its excess capacity to raise or lower production to stabilize prices—which it sometimes does). Demand will fall substantially in response to higher prices but it takes years—for example, people don’t change their driving habits quickly when gas prices go up, but some will switch to better mileage models the next time they buy a car. (This was not known in 1973-74, when oil and gas were regarded as “necessities” that people had to buy, almost regardless of price.)

Oil and gas prices will trend upward in the future because of rapidly growing demand--not in the developed West, where it is relatively flat, but rather in the third world. The prime mover will be China, a country of 1.35 billion people (more than four times the US population)  whose GDP is growing at an extraordinary 10 percent annually (meaning that output doubles every seven years) and within a decade it will surpass the US as the world’s largest economy. Every year millions of Chinese become able to afford a car and the other energy-demanding amenities of modern life. China’s oil use consequently has been doubling every 11 years, and now accounts for about 10 percent of the world total. Meanwhile India –with one billion people—and other poor countries are also developing and increasing their energy use, plus world population will grow by two billion by 2050.

As for supply, new oil sources are becoming harder to find and more expensive to develop, despite impressive technological advances by the oil companies. The bottom line is that the price of oil must rise to keep supply and demand in balance.

The chart shows the price history since 1970, and also that gas prices depend almost entirely on the cost of crude oil. The first price surge occurred when the mostly Muslim OPEC countries—angered by Western support for Israel in the 1973 Six-Day War--quadrupled their price for crude to the unheard-of level of $12 per barrel (it’s now over $100!). A second surge followed the 1979 Iranian revolution and Iraq’s 1980 invasion of Iran, resulting in production declines in both countries. By contrast, the two more recent price spikes have less dramatic causes—mainly concern about political stability in key producing countries and expectations that future supply will not keep up with demand.

To an old analyst like me, the chart also shows four fairly distinct periods: soaring prices during 1973-80; falling prices during 1981-86 (as non-OPEC oil production soared by 10 million barrels per day in response to the earlier high prices); a period of relative stability that lasted until about 2003; and, finally, the post-2003 period of rising prices. While this last trend was interrupted by a sharp price decline in 2008, as the economy slipped into the worst recession since the 1930s, the decline was short-lived and someday even $4 gas may be just a fond memory.