Fuel for Thought

Mackubin T. Owens

October 1, 2006

In August, the price of a gallon of unleaded regular gasoline surged to over $3.00, up from about $2.20 at the beginning of 2006. But since that time, the price at the pump has been falling by more than a penny per day. The price of a gallon of unleaded regular has dropped to around $2.40 and many analysts are predicting that the price will decline farther to at least $2.00 a gallon. In addition, the same dynamics that have driven gasoline prices down may well do the same to heating oil prices this winter.

This should be cause for celebration. But instead, a recent Gallup Poll shows that 42 percent of the respondents believe the Bush administration is manipulating the price of gasoline in advance of the elections.

But this is nonsense. The price of gasoline is determined by market factors: on the supply side, the price of crude oil, the availability of domestic refining capacity, the cost of environmental regulations, and of course taxes; on the demand side, the season of the year (demand for gasoline peaks during the summer months), and the health of the economy. The confluences of these factors during the summer of 2006 accounted for the high prices of gasoline and changing conditions are contributing to the subsequent decline in prices at the pump.

The price of crude oil reached record levels in August as a result of geopolitical uncertainties, especially the fear of Iran-related supply disruptions. To hedge against future price increases, refiners stockpiled crude oil. This added to world demand for oil, which, when combined with flat world output, pushed the price of a barrel of oil to over $70.

Domestically, refinery output was still lagging behind capacity as a result of Hurricane Katrina. And finally, federal, state, and local environmental regulations not only helped to push gasoline prices higher by requiring the use of expensive additives, for example the new federal ethanol mandate, but also tended to “fragment” the gasoline market according to different regulations, for example mandating the use of “reformulated gasoline” (RFG) in certain areas of the country, making it difficult if not impossible for suppliers to shift gasoline stocks efficiently from one part of the country—or even one part of a state—to another.

Meanwhile, US demand for gasoline, already strong due to a robust economy, surged as Americans took to the highways during the summer vacation season. American demand for gasoline appears to be inelastic—a substantial increase in price produces only a small decline in the quantity demanded. This is because consumers don’t seek substitutes in the short run, and even with the price increases of the first part of the year, Americans were still spending a smaller proportion of their total wealth and income on energy than they used to.

So what has changed? The price of crude has fallen precipitously as geopolitical concerns have lessened and refiners have begun to draw down their crude oil inventories. Refining capacity, lost as a result of Katrina, has come back online and this has been a milder hurricane season than predicted. The price of ethanol has fallen, cancelling out a massive price spike that followed congressional passage of a law requiring it be used as a fuel additive. These have improved the supply situation. The end of summer has dampened demand for gasoline.

But while Americans have gotten a break at the gasoline pump since the summer peak, the fact is that in the long term, the price of fossil fuel products will continue to rise unless we take measures to prevent it. This is because world oil demand—generated especially by economic growth in China and India—reached unprecedented levels last year and will only continue to grow. Of course, US demand for oil and gas continues to grow as well. Americans currently consume about 20 million barrels of oil daily, of which about 60% is imported. The Energy Information Administration expects imports to reach 70% by 2025.

Rising fuel prices over the long term and US dependence on imports require us to look closely at the opportunity costs of many recent environmental policies and to rectify those that prevent us from increasing the domestic supply of energy. If we are serious about stemming the rise in fuel prices and reducing our vulnerability to disruptions of foreign energy supplies, Congress must take certain steps.

To begin with, it should permit the exploitation of the abundant deposits of oil and gas that lie beneath Federal lands and coastal waters. The fact is that almost 90% of the Outer Continental Shelf (OCS) acreage in the lower 48 states is off-limits to production (including the entire Atlantic and Pacific OCS and most of the Eastern Gulf OCS.

At a minimum, Congress should open the Arctic National Wildlife Refuge (ANWR) to drilling. The body should also pass legislation granting the federal government the authority to waive federal and state environmental and product quality fuel requirements. Finally, it should permit federal agencies to grant short-term relaxation of federal and state requirements in the event of emergencies to expedite bringing pipelines and distribution facilities on line.

When it comes to energy policy, we need to forget the silly conspiracy theories. The technology is available to ensure that we can have both access to energy supplies and a clean environment. All it takes is the political will to make the right energy decisions.

Mackubin T. Owens is an Adjunct Fellow of the Ashbrook Center and an associate dean of academics and a professor of national-security affairs at the Naval War College in Newport, R.I.