ND Business Magazine

Feature - Spring 2006

What’s Up With Gas Prices?

By Peter J. Howe


Many Americans were still getting used to the idea of $2-a-gallon gasoline when prices roared past the $3 mark in parts of the country last September after Hurricane Katrina ripped through the Gulf Coast oil patch.

Although prices later settled back down, most industry experts think the post-Katrina spike only dramatized a new reality: The age of cheap gas is over. And there’s a serious chance that before too many more years are over, $3 gas will look like a bargain.

The factors affecting this week’s exact price of gasoline change constantly. But over the longer term, some fundamental things have changed since the 1990s.

Rapidly modernizing countries like China and India are demanding more and more gasoline. Compared to a decade ago, in the wake of the second war in Iraq and the Sept. 11, 2001 terrorist attacks, the world today looks to American eyes like a permanently less peaceful place, where on any given day something could happen in politically volatile oil countries like Iraq, Nigeria, Russia or Venezuela. That’s added a new chronic-risk premium to petroleum and gasoline prices.

Saudi Arabia’s ability to guarantee cheap oil for the U.S. seems far more questionable than it was a decade ago. And one big thing has stayed the same: Americans still love big cars, pickup trucks and long commutes. Even though pump prices have jumped, in real terms they were still well below 1979-80 peaks this past winter. High prices have put no crimp on U.S. gasoline demand; demand actually continues to increase.

“For the long term, I’d bet on $4 (a gallon) gas before I’d bet on $2 gas,’’ says Dennis Foster, a private energy investor who serves on trucking company and utility boards. “I just think we’ve got to live with increasing gas prices.’’

When Katrina slammed into the Gulf Coast and took down one-eighth of the country’s gasoline-refining capacity, average national prices soared by 50 cents compared to the beginning of August, according to the American Automobile Association/Oil Price Information Service.

Suddenly, the price of gas was a front-page story—even though in the previous five months, prices had already risen by 50 cents because of less dramatic long-term factors like Chinese demand and commodity-market angst over political strife and terrorism threats in oil countries.

Bob Wohleber (’73), senior vice president of Kerr-McGee Corp., an Oklahoma City oil and natural gas producer says, “I think the long-term trend is probably oil staying above the $40 to $45 level per barrel, not the $20 we saw in the 1990s. Certainly there will be peaks and spikes that can take it to $70 or $80. I don’t think that we’re going to go back to the good old days.’’

The U.S. Energy Information Administration projects West Texas Intermediate Crude Oil, a widely followed industry benchmark, will average $63 this year, up from $56 last year, but drop back to $60 in 2007.

However, in a March 2005 “Ten Years Hence” speech at Notre Dame’s Mendoza College of Business, Ross Pillari, president of BP’s 17,000-station BP America operation, said his company has actually given up trying to guess where prices will go.

“Taking the view of the future is always challenging,’’ Pillari, a 33-year industry veteran, told more than 300 students at Mendoza. “In fact, it may surprise you to know that BP does not even try to forecast the price of oil and gas. The complexity of the global markets and the factors impacting them are impossible to predict. All you can do is look at the fundamentals and then be prepared for anything to happen, positive or negative, and develop the options that fit the context as it evolves.’’

Factors Influencing Gas Prices

Gary L. Neale, chairman of NiSource Inc., a Merrillville, Ind., energy conglomerate that owns pipelines and natural gas and electric utilities in nine states from Indiana to Massachusetts, says, “Prices are affected by basically three factors, whether you’re talking about gasoline or natural gas or a lot of other commodities: first, supply conditions, where it’s coming from; second, the infrastructure it takes to get it to the market, whether that’s refineries or pipelines or storage facilities; and third, demand. All three of those things can affect prices negatively or positively.’’

Most of the time, half the pump price of gasoline, as a rule, reflects the cost of oil. Taxes, middleman fees for refining and transportation, and a usually meager gas station markup of a few nickels per gallon account for the other half.

In the case of gasoline, however, the price is affected by a whole host of what Neale calls “supply conditions’’ and potential bottlenecks. For many years into the early 2000s, the world oil system normally maintained a potential cushion of about 3 million barrels per day between normal demand and maximum potential supply. But factors including a jump in Chinese demand by 1.6 million barrels a day in the last two years, and recurring attacks on Iraqi oil facilities, have cut that cushion to about 1 million barrels most days now, BP’s Pillari says.

Pump Price per gallon
Petroleum producer
Refining costs plus profits
$ .53
Distribution and marketing
$ .22
State tax (average)
$ .21
Federal tax
$ .18
Service station markup
$ .15
Note: figures, other than taxes, are illustrative estimates, based on industry averages calculated by U.S. Energy Information Administration and other sources.

That means even small shocks to oil supplies can lead to magnified price impacts. “It’s a nervous market. It’s a jittery market,’’ Neale says. “The Iran-Iraq situation isn’t making it any easier. Nor is Venezuela,’’ led by U.S.-bashing strongman President Hugo Chavez, which is among the top five sources of U.S. oil imports.

Most industry analysts think the world is probably at, or close to, the maximum capacity for pumping oil from the ground, and U.S. production actually peaked in 1970. Tar sands and “oil shale” rock formations in Canada and the western U.S. may theoretically hold the equivalent of a Saudi Arabia’s worth of future gasoline. But two great unknowns are what kind of environmental horrors might be unleashed in extracting them, and how much energy would be required to essentially cook the oil out of them—energy which could most easily come from burning natural gas, which would only worsen the energy price squeeze on homeowners and businesses.

Many motorists howled last fall when local service stations sometimes raised pump prices 25 or 50 cents in a day, noting that in many cases they were only selling gasoline they bought at a price well below the spot market prices during the post-Katrina panic. But most of the nation’s 170,000 gas stations operate on slim profit margins, making far more money on soda pop and lotto tickets than gasoline. Owners consistently say they raise prices now to protect themselves against even more expensive gasoline a few days later, or a sudden market drop that leaves them stuck with thousands of gallons in inventory well over prevailing market prices. Despite widespread cries for investigations into price gouging, states including Massachusetts never prosecuted anyone. “It’s a tough case to prove,’’ says Alice Moore, chief of the public protection bureau in the Massachusetts attorney general’s office.

True, oil companies earned record profits in 2005. At $36.1 billion, ExxonMobil achieved the highest corporate profits in the history of American capitalism. But it’s worth noting that Exxon is a huge company to begin with, and at 9.7 percent of total revenues, Exxon’s profit rate was still only about half that of Bank of America or pharmaceuticals giant Johnson & Johnson. In a boom-and-bust industry, last year was indeed a good year, but the American Petroleum Institute notes that in the last five years, oil companies have made less than six cents per dollar of revenues, close to the average for all U.S. companies.

The chief economist for the U.S. Commodity Futures Trading Commission, James Overdahl, declared last fall, “Energy prices are being set fairly in an open and competitive environment.”

Another source of volatility in prices is what oil industry officials call the profusion of “boutique blends” of gasoline. Because of state and federal environmental laws, and varying state policies on gasoline additives, more than 18 different kinds of gasoline have to be sold in different jurisdictions and at different times of the year, including four in southern New England alone.

“It just gives you a lot less flexibility,” Gary Kaneb, president of Gulf Oil LP in Chelsea, Mass., said in a Boston Globe interview. “That adds to the ultimate cost for the consumer and adds to the volatility of prices and vulnerability of supply.”

To all those factors, add relentless growth in worldwide gasoline demand. Even as prices soared in the U.S. last fall, daily demand for gasoline barely budged, dropping from 9.26 million barrels per day in the April-June quarter to 9.16 million barrels per day in the October-December quarter, according to the Energy Department. Its Energy Information Administration predicts full-year average demand for gasoline in the U.S. will keep growing, from 9.13 million barrels per day last year to 9.28 million barrels per day this year and 9.44 million barrels per day next year.

Now add China, India and a host of other fast-growing nations who love cars no less than America. Wenchao Su, oil analyst with ESAI, a Wakefield, Mass., energy forecasting firm, predicts global gasoline demand will grow by an annual rate of 4.7 percent in the second and third quarters of this year. To some extent, predictions that Chinese demand will send oil prices skyrocketing have become a self-fulfilling prophecy. “You have people trading in the markets who say, ‘If this Chinese demand continues, we’re going to have $50 oil,’ so we have $50 oil today,’’ NiSource’s Neale says.

Alternatives to Oil

Can anything be done? Frank P. Incropera, who is dean of Notre Dame’s College of Engineering and has studied American energy dependence extensively, says, “We’re probably going to continue to find ways to make liquid fuels for transportation, but the cost will continue to go up.’’

Despite their endorsement by President George W. Bush and others, hydrogen-powered cars and trucks, in Incropera’s view, are “not a solution for the near future. If these things became a reality by 2050, I’d be surprised,’’ because technologies for extracting hydrogen from water or other sources will remain prohibitively expensive.

Incropera is, though, bullish on prospects for motor fuels made from coal (which kept Germany’s war machine rolling during World War II and can be produced more efficiently and cleanly now) as well as ethanol, fuel produced from corn or other crops. Historically, ethanol has been dogged by a problem called “net energy gain,’’ a reference to the fact that typically producing 10 gallons of ethanol has required burning 4 gallons of fuel, the dean says. He also points to wasteful government spending on “pork barrel projects” to promote ethanol. But new ethanol blends that come from cellulose-based plants, specifically switchgrass that can grow across the Great Plains and the South, are “worth pursuing” as a way to produce fuel far more efficiently.

Although BP has pledged to invest $8 billion over the next decade in alternative energy technologies, BP’s Pillari doesn’t expect alternative fuels to meet more than a small, if growing, share of U.S. gasoline demand anytime soon. Citing International Energy Agency projections that global oil demand will climb by 32 percent between now and 2020, Pillari told his Notre Dame audience, “The reality is that the world will continue to be greatly dependent on oil and gas for decades to come.’’

That’s exactly the problem, Incropera says. “You cannot address this problem with supply solely.’’ He calls it “a tragedy” that Washington policymakers have not imposed stronger fuel-efficiency standards on Detroit automakers. And as long as Americans continue to love one-person commuting and big sport utility vehicles and pickup trucks, they can’t complain about gasoline staying well over $2.

“I don’t think the American consumer of transportation fuels should be blaming the system for the high prices at the pump,’’ Incropera says. “They need to look more at themselves.’’

—Peter J. Howe is a business reporter for The Boston Globe who covers energy, utilities and aviation.



Copyright © 2006 University of Notre Dame All Rights Reserved Last Updated on: May 9, 2006