Gasoline: $12 Dollars/Gallon Inevitable

According to this article, Charles T. Maxwell is predicting that gasoline will eventually reach $12-$15/gallon. Why the pessimistic forecast? Many analysts believe that we are in a period where oil production is going to decline, and yet demand is increasing. The obvious result is higher prices of oil, and thus gasoline.

“[T]he prices that we’re paying at the pump today are, I think, going to be ‘the good old days,’ because others who watch this very closely forecast that we’re going to be hitting $12 and $15 per gallon,” Hirsch said. “And then, after that, when oil — world oil production goes into decline, we’re going to talk about rationing. In other words, not only are we going to be paying high prices and have considerable economic problems, but in addition to that, we’re not going to be able to get the fuel when we want it.”

[…]

“[Maxwell] expects an oil-induced financial crisis to start somewhere in the 2010 to 2015 timeframe,” Energytechstocks.com reported. “He said that, unlike the recession the U.S. appears to be in today, ‘This will not be six months of hell and then we come out of it.’ Rather, Maxwell expects this financial crisis to last at least 10 or 12 years, as the world goes through a prolonged period of price-induced rationing (eg, oil up to $300 a barrel and U.S. pump prices up to $15 a gallon).”

This prediction seems overly pessimistic to me. At $12/gallon a person who fills up a 12 gallon tank once a week is going to be spending about $5,000 more per year than if the price were $4/gallon. At such a point, switching to a hybrid would make economic sense so long as the hybrid’s higher cost was under that $5,000 differential. Further, the technology for hybrids and other solutions will continue to advance, and in fact might accelerate. After all, with gasoline and oil prices rising at such a rate someone finding an alternative for oil in some of the products that use oil would stand to reap a not insubstantial windfall. In other words, we not only see an income effect, but also a substitution effect.

The potential problems are political busybodies who inject themselves into the market process because they think they can make decisions for a large number of people better than the people themselves. This can lead to bad incentives that actually exacerbate the problem, not make it better. For example, if oil and gasoline prices go up because of increased demand, trying to keep prices low wont solve the problem, it will simply make the problem worse.

Prof. James Hamilton suggests that there might be a bubble in oil prices that could be contributing to the current high prices. To the extent that the recent run up in prices are the result of speculation and if they are part of the basis for forecasting $12 to $15/gallon prices then that forecast might be overly pessimistic. Still, if the actual price turns out to be $10.50/gallon that is quite an increase. Charles Engel also weighs in on the possibility of an oil bubble here. And let me be clear, even if there is an oil bubble it doesn’t mean oil prices are going to drop to some low level like $60/barrel. But Engel provides one reason to think the idea of $300/barrel by 2010 or even 2011 or 2012 is overly pessimistic,

I can understand why market fundamentals make the price of oil high — but why is it rising? Let me explain this question. Oil is a durable, storable commodity. If the increase in excess demand is expected by the markets, it should be incorporated in the price immediately. That is, if the markets have understood for some time that rising demand from emerging markets was squeezing the market for oil, the price should have jumped immediately to reflect those expectations. If markets expected rising demand four years ago, and could calculate that the price would be $120 today, then the price should have been a lot higher than $40 back then. Anyone who bought a barrel of oil in 2004 would have made a 200% return over those four years. But in anticipation of $120 oil prices in 2008, markets should have bid up the price back in 2004.

The same logic applies today. Suppose you have good reason to expect prices to be $300/barrel in June of 2012 (the mid point in Maxwell’s prediction time frame above). If you bought as much as you could now and stored it till 2012 (about 4 years) you’d earn over 222% return on your investment. Even accounting for storage costs you’d make a killing. This kind of incentive would push up the price right now. We aren’t seeing it so most investors don’t believe Maxwell’s prediction.

But you say, “Yes, but as Engel points out we did go from $40 to $120 going from 2004 to 2008, so why can’t it happen again?” Well it could. The point Engel is making is that based on the fundamentals back in 2004 nobody expected this price. This price increase was unexpected—i.e. a low probability event. I’d argue similarly with the Maxwell prediction. The price could still end up at $300/barrel, I just don’t think it is likely at this point in time.

FILED UNDER: Economics and Business, , ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. John Burgess says:

    Oil is a ‘durable’ commodity as long as it remains in the ground. Once pumped, it starts to oxidize, volatilize, and degrade. The more refining it gets, the faster it degrades.

  2. Bithead says:

    Steve,

    When they start in with that nonsense, it’s usually the first sign that the bubble will break shortly, and this is people trying to extend the ride on the wave a bit longer by letting more people (read that less experienced people with some money to throw way) to help them along.

    You may want to look at the Telegraph, today. They tell a different story.

  3. brainy435 says:

    “This can lead to bad incentives that actually exacerbate the problem, not make it worse.”

    Say what now?

    Also, if people were paying an extra $5k for gas a year, the hybrinds are attractive anywhere under 5k per year, not just 5k total. Of course that number only holds for hybrids that save you, what, 66% of the gas a comparable combustion engine would, which is probably not realistic.

    In any event, this is what happens when government tries to control markets.

  4. I hope the Government should careful about it this matter and they should control this market otherwise peoples have to pay more.

  5. Zelsdorf Ragshaft III says:

    What is likely to happen long before we get ripped off to that extent. The American people will throw out the Democratic congress who has allowed tree huggers to dictate policy and disallow oil exploriation, extraction and refining. There is more than enough oil in oil shale and off our coast and and Anwar to supply this nation for quite some time. I, for one, am tired of these idiots attacking our capitalist system through environmental issues. Soon, the people will say enough. Hang them all.

  6. Dyre42 says:

    Even if what Maxwell said is true it could be worse. It could have been the King of Saudi Arabia making the prediction.

  7. Michael says:

    Suppose you have good reason to expect prices to be $300/barrel in June of 2012 (the mid point in Maxwell’s prediction time frame above). If you bought as much as you could now and stored it till 2012 (about 4 years) you’d earn over 222% return on your investment. Even accounting for storage costs you’d make a killing. This kind of incentive would push up the price right now. We aren’t seeing it so most investors don’t believe Maxwell’s prediction.

    Wait, so if the price of oil were expected to go up in the future, it would be going up now, which obviously it is, but our current increase in oil price isn’t evidence of this phenomenon? I’m confused on something here.

  8. […] Steve Verson@OTB notes an article by Charles T. Maxwell that predicts the advent of $12-$15 per gallon gas in the 2010-2015 range. I also heard a story yesterday on All Things Considered about a pending report regarding global oil supply (and the news wasn’t good). While I cannot find that story online, Kevin Drum posted on the same report from the IEA yesterday. […]

  9. brainy435 says:

    How did an Amazon ad get linked to my comment?

    Weird, especially considering I am not a religious person.

  10. steveplunk says:

    Does Maxwell have money in Oil futures? Does Maxwell get his name published for such outrageous predictions? Will Maxwell pay any real price for being wrong? I think we can see some bad incentives at play here.

    While you are on the subject, Mr. Verdon, I would like to get your take on the hedge funds influence on oil and hedge funds in general. Do you see them as a good thing for the economy or a bad thing? Is there a sound defense for an elite group of investors with the power and money to influence markets and acting mostly unregulated to even exist? Are they due for more regulation?

  11. Dave Schuler says:

    We’re already in the price territory in which alternatives begin to look a lot more attractive (as Alex’s post above highlights). If the price spike continues for any length of time I expect we’ll see a lot of exploding garages (homebrew, storage, etc.).

    I don’t know, Steve. If there’s a bubble it’s a pretty long-lived one. The time horizon for price increases quoted above doesn’t start early enough. IIRC prices tripled between 1998 and 2004, too.

  12. D. H. Strong says:
  13. Dutchgirl says:

    In the Netherlands the official prise of regular gas is 1.588 euro per liter (about 10 dollars per gallon), prices at the pump can be much higher depending on location. People still drive there, but the public transit there is an efficient and attractive alternative.

  14. Michael says:

    D.H. Strong,
    The problem with Wind and Solar is that it’s not storable, you have to use it when you get it, it’s not controllable, you can’t ramp it up or down on demand, and it’s not reliable, you’re at nature’s mercy for your energy source.

    Geothermal and Hydro don’t have the above problems, but you’re limited to where you can get that energy from. If you live somewhere far from a good source of hydro or geothermal, you can’t use them. Even when they are available, they have a not insignificant environmental impact.

    Hydrogen has problems too, it’s hard to store and it’s hard to create. Most sources of of hydrogen today are from hydrocarbons, especially fossil fuels. Getting Hydrogen from pure water takes more energy that you can get back, so that’s a non-starter too.

    If you want to replace oil and coal, you need an energy source that meets all of these criteria:
    1.) Be storable
    2a.) Be transportable or
    2b.) Be producable anywhere
    3.) Be able to control the rate of energy released
    4.) Have a consistent and predictable availability

    So far the only non-fossil fuels that meet those criteria are biofuels and nuclear. Biofuels currently suffer from a scalability problem, and nuclear has a waste disposal problem.

    Fusion power is the only long-term sustainable source of energy, but it’s been “10 years away” from breaking even for about 30 years now. Still, if any technology deserves our money and attention, I think here.

  15. Steve Verdon says:

    I don’t know, Steve. If there’s a bubble it’s a pretty long-lived one. The time horizon for price increases quoted above doesn’t start early enough. IIRC prices tripled between 1998 and 2004, too.

    How long did the housing bubble last? How long did the dot.com bubble last?

    Further, not all price increases have to be due to bubbles. That is, price increases in 1998 – 2004 may have logical explanations such as the increase in world wide demand, the Iraq war, etc. In those cases you might very well expect prices to go up, so you could expect to see steady increases in oil prices over time which have nothing at all do do with a bubble.

    Wait, so if the price of oil were expected to go up in the future, it would be going up now, which obviously it is, but our current increase in oil price isn’t evidence of this phenomenon? I’m confused on something here.

    What Hamilton and Engel are saying is that they see no reason for these price increases. In short, it isn’t based on anything indicating that oil should be going to $300/barrel, other than that the price is rising. Now prices can rise for good reasons, or no reason at all. The latter case is when you may very well have a bubble.

    First off, get over that “hybrid” nonsense. The electricity is still coming from oil. Get back to basics.

    Uhhhmmmm no. Currently the fashionable sources of electricity are coal, natural gas, and nuclear, with a smattering of renewables.

    An entire hydrogen-cell economy is now almost as affordable as oil. New ways of harnessing geothermal and hydrodynamic are now at least as affordable as oil. Get outside the box, and wake up and smell the 21st century.

    Which you are going to use to do what? Make electricity? Hmmm, so which statement of yours is true, this one or the one I quoted immediately above?

  16. Bithead says:

    Weird, especially considering I am not a religious person.

    So, you don’t worship Amazons?

    I’ve made my points elsewhere.
    Government is the reason we’re in the current situation. We cannot, therefore, logically depend on government to get us out of it.