Don’t Count on Lower Gas Prices Over the Long Term

Q: Gasoline prices have trended lower recently. Have the dynamics changed?

A: As we discussed in May, oil and gas prices are a function of supply and demand. When supply is limited and demand is high, prices tend to rise. When there’s an oversupply of oil or demand is weak, prices tend to fall.

Supply hasn’t changed much recently. The availability of crude oil and capacity to turn it into gasoline and other refined products are still tight. Also, the war in Ukraine rages on, with sanctions on Russia cutting off a significant source of the world’s oil supply.

On the other side of the coin, we have seen demand soften, which helps explain why the price of your fill-up has declined from recent peaks. See Figure 1. We think several factors are at play. First, the likelihood of a recession is climbing as the Federal Reserve (Fed) moves aggressively to combat inflation with its rate-hiking strategy. We expect demand for oil to decline if the economy slows or contracts.

Second, high gas prices have changed consumer behavior – we’re driving less. The Energy Information Administration (EIA) recently trimmed its demand forecast to 5% lower than the summer of 2019 – the last driving season before the onset of COVID.¹

The pandemic is limiting demand as well. Even though we’ve seen a return to more typical economic activity in many regions, an aggressive zero-COVID lockdown policy continues in China, the world’s second-largest economy. Fresh outbreaks in July led to new lockdowns limiting the movement of millions of people in the country’s largest cities.²

Q: Are pre-pandemic gas prices returning?

A: It’s possible, but unfortunately, we think any substantial or sustained relief would result from events that would be bad for most of us. For example, a significant slowdown in economic growth or a recession would likely bring lower prices. When the economy slows or contracts, business activity and consumer spending decline – as does energy consumption.

We have a recent example. The collapse in oil and gas prices during the pandemic recession was extreme, but it demonstrated how crude and fuel prices react when demand deteriorates.

From a supply perspective, we don’t see material additions of crude oil or refining capacity hitting the market anytime soon. There are no immediate prospects for peace in Ukraine, and President Biden has been unable to persuade Saudi Arabia and other oil-producing countries to materially increase output.

Q: Who gains the most from higher gas prices?

A: Your first thought might be that the gas station operator benefits from higher prices. But that’s usually not the case. Since stations don’t produce the fuel they sell, they’re merely passing on the high prices they had to pay refiners to procure gasoline.

Refiners, on the other hand, are enjoying record-breaking profits. See Figure 2. Their profit comes from the difference between what they’re paying for crude oil and what the market is willing to pay for refined products like gasoline, diesel and jet fuel. Their costs are mostly fixed, so any rise in wholesale prices for refined products boosts their profit margins.

Historically, refiner margins stayed within a somewhat predictable range. When profits were high, refiners would increase capacity to take advantage of the situation. Prices would eventually decrease when supply caught up with demand.

This time, profit margins broke through the top of the normal range because demand is high, supply is limited and wholesale buyers are bidding up the price of the available gasoline. See Figure 2. As a result, we’re paying higher prices at the pump.

Q: Will electric vehicles and gasoline alternatives reduce my fuel costs?

A: In the long-term, the switch to electric vehicles (EVs) and alternative fuels may reduce your spending on fuel. In the meantime, however, the transition will likely sustain higher gasoline prices than you were accustomed to before the pandemic.

On the supply side of the equation, refiners have no incentive to increase their production capacity. They’re earning record profits and building new facilities to bring more gasoline to the market would lead to lower prices.

Even if energy companies wanted to build new refineries, it would be hard for them to justify the expense to their shareholders. It costs billions to bring new refining capacity online, and the useful life of those facilities spans several decades.

The slow transition away from fossil fuels also comes into play. Analysts predict demand for refined products, like gasoline and diesel, will peak in the next 10 years. The overall demand for crude oil could peak five to 10 years after that. If you’re an energy company executive, it’s hard to make the case to shareholders that it’s wise to invest in a facility with a 30-year payout when the demand for the product it produces is going to peak in the next 10 to 20 years.

Q: Europe is bracing for an energy crunch this winter. Is the U.S. also at risk?

A: The war in Ukraine has created significant energy uncertainty in Europe, which is heavily dependent on Russian natural gas. Russia has already cut off a handful of countries and could use sanctions as an excuse to reduce or stop sending natural gas to the rest of Europe.

Skyrocketing natural gas prices on the continent are having profound impacts. In addition to higher energy bills, consumers face the possibility of conservation measures such as limitations on how high they can set their thermostats this winter.

Meanwhile, businesses face the prospect of rationing. Some are switching to alternative energy sources such as oil or coal. Such measures are only a bandage for a more significant problem that could further disrupt supply chains. The impact could be exceptionally high in energy-intensive industries such as paper and packaging and chemical production.

This scenario is unlikely to play out in the U.S., which has an abundance of natural gas and is a net exporter of natural gas and oil.