The markets for oil and gas can differ

Aside the controversy of using a campaign worker’s spouse (see the update) to pen what might otherwise have been seen as an interested letter to the editor, I thought Susan Gaertner’s letter about the claim of Michele Bachmann that the price of a gallon of gas could be $2 in the US in four years deserved some commentary.  It is really a bold claim Rep. Bachmann (R-MN, in whose district I live) makes and thus worth consideringin more detail.

Most of the letters you read these days involve the EIA’s estimate of the effect of opening drilling in ANWR.  As I wrote about this last week, the report assumes that the price of a barrel of oil in 2020 would be less than $60.  If $140 a barrel produces a price of $4 for gasoline, what does a price of $60 a barrel for oil produce?  Those of you who answered “$2” can stop now; you’ve just agreed with Rep. Bachmann.  (Though that’s 2020 versus Bachmann’s forecast date of 2012; if you’d like to argue a price that stays at $140 through 2012 — or higher — and then falls to $60 by 2020 so that EIA is right and Bachmann is wrong, I invite you to tell that story and wish you good luck.)

So let’s suppose EIA is wrong about that forecast.   This kind of cuts the legs out from Gaertner’s substantive claims, but let’s answer her question for her anyway.  What might additional drilling produce for a price change?  The key lies in understanding it’s about more than just additional oil production.

James Hamilton posts this evening that demand for gasoline in the US appears to be more responsive to prices now that we’re at $4 than it was when we were at $3 a gallon.  I have talked about this in terms of the “second law of demand“: consumer responsiveness to price changes is time dependent and expectations dependent.  If the price rise is temporary, you smooth your consumption of gasoline through a combination of less spending on other goods and by saving less.  If on the other hand you believe it is permanent, you make bigger changes, like dumping your SUV, riding a bike or buying a more fuel-efficient car.  As that shift occurs, you move from a very inelastic demand curve to a more elastic one, and that produces a snap-back of prices towards where you were before.  Jim’s graphs would indicate that since the beginning of 2008 we are seeing some of that.  That should give one some hope that the price decline we’re experiencing right now could be the beginning of a longer period of lower gas prices.

But it’s also expectations-dependent for suppliers, particularly at the refinery level.  There’s a very interesting post on VoxEU from Lutz Kilian of U. Michigan regarding the sources of increase in gasoline prices.  Most importantly, his model distinguishes the market for gasoline and the market for oil.  Domestic demand for gasoline and speculation over oil futures play almost no role in the price of gas; foreign demand and supply uncertainties explain most of the change in Kilian’s model.  That result makes sense to most observers (it fits, for example, that CFTC report on speculators.)  The price spikes following Hurricanes Katrina and Rita reflected very tight refining capacities that were upset.  Those shocks went to gas prices, with negligible impact on world oil prices.

Part of the plan pushed by Rep. Bachmann is to pass HR 6139 to cut the bureaucratic hurdles that impede the construction of new refineries.  Sure, they take years to produce, but the prospect of additional capacity would reduce uncertainty about gasoline supplies and reduce inventories (which, unlike crude, have been going up versus a year ago.)

Inventory uncertainty, then, can play a substantial role in gasoline prices.  Easing the regulatory chokehold on gasoline production could take much more off the price of gasoline today than anyone’s projection of the impact on crude oil.

FILED UNDER: Economics and Business
King Banaian
About King Banaian
King Banaian has served as Dean of St. Cloud State University’s School of Public Affairs since July 2014 and has been a Professor of Economics there for three decades. A former State Legislator, he hosts an eponymous talk radio program. He has his MA and PhD in Economics from the Claremont Graduate University. He did a brief guest stint at OTB in July 2008. Follow him on Twitter @banaianshow.

Comments

  1. Scott Swank says:

    While there is nothing like agreement on the topic, a reasonable number of experts suspect that we are at or at least near peak world-wide oil production. If in fact we are simply never going to get much more oil out of the ground per year than we currently are, then building more oil refineries is a money losing proposition. My guess is that this is why we have not had any new refineries in the last some years.

    But then I’m no expert _and_ I’m guessing…

  2. peterh says:

    Yes….I’ll agree…you’re no expert and you “are” guessing….”peak oil” makes for nice sound-bytes as the price for oil rises, but in reality, is not even on the radar screen on reasons why WTI traded beyond the $140 level…..crude is not short…..quality maybe….quantity….no….but…I’m only scratching the surface on many factors involved on the upside and the current downside….Don’t take it as a rebuke…..I lack tack…..

  3. spencer says:

    Crude oil is an intermediate product in there is no final demand for crude, only for refined product.

    So demand for oil is partially a function of refining capacity. If refining capacity is down demand will be down and if refining capacity expands demand for crude can expand.

    So limited refinery growth keeps demand for crude oil weak and the cost of refining oil is only an extremely small share of the cost of gasoline.

    So explain to me again how expanding crude refinery capacity leads to lower oil prices.

  4. Scott Swank says:

    peterh,

    You missed my point. I’m not saying that peak oil caused the $140/barrel prices for crude, nor the $4.xx/gallon for gasoline. Greater refining capacity could help even out some swings in prices. However, if we are not by and large going to need more refining capacity than we currently have, then building more refineries is a money losing proposition. I am suggesting that investors are not interested in putting their money into refineries.

    Additionally, as the price of oil goes up consumers and make different medium term decisions (fewer SUVs) which causes the demand to become more elastic than it is in the short term. This further diminishes our need for more refining capacity.

  5. kbanaian says:

    spencer, I’m talking about the price of gas, not oil.

  6. Wayne says:

    Causing a bottleneck by limiting refinery capacity won’t work. One other countries demand will still be rising. Two if demand for refine products exceeds supply either the price for refine price will skyrocket or more likely we will import refined products. This would results in large profits for overseas refineries.

    Yes the price of crude doesn’t necessarily have a direct ratio to the price of the refine product. However since the profit margins are so small the ratios has been close. I haven’t look up the raw data on that but I’m sure it is out there.

  7. Steve Plunk says:

    Spencer, I understand your point but how do we explain the jump in crude prices when a refinery has a fire and shuts down? With less refining capacity the price of crude should drop but instead shoots up.

    kbanaian, in the last couple of years I have seen diesel fuel go from the least expensive motor fuel to the most expensive. Current retail differential locally is 60 cents per gallon higher than unleaded gas. Is this purely demand driven or do you think the less elastic demand curve for diesel has an effect?

    Scott Swank, I think additional refining capacity could stop the swings in price from seasonal shutdowns, accidental shutdowns, and reformulation periods that refineries go through. Additional refineries could be located to minimize transport costs of refined products as well.

  8. Bruce Moomaw says:

    So: if it’s construction of additional refineries that has a real chance of quickly lowering current gas prices, then why are Bush and McCain endlessly emphasizing ANWR and offshore drilling instead as the way to do so?

    And since — after those new refineries have eaten up all our current inventories of stored crude oil — gas prices will rise right back to about their current level, and increased ANWR and offshore drilling will then raise our supply of crude and thus re-lower our gas prices only slowly, is there not a good possibility that other technological measures (such as the construction of steadily higher-mileage cars and the expansion of railways) will actually work faster and more cheaply (including lower pollution costs and, in the case of railways, a longer useful infrastructure lifetime) than such drilling will?