When I get together with my economist friends, I’m told we’re now in the boom times.
Inflation is under 3%, and the US economy is “the gift that keeps on giving!”
Unemployment is at a 4.5% record low and the stock market is approaching 14,000. We seem to be living in a “Goldilocks economy," with everything just right.
But then my normal friends ask me why gasoline is headed for $3.50 a gallon - and how can gasoline keep going up without killing off the stock market’s golden goose? After all, the housing market is already melting down. Last year when oil shot up, the DJIA tanked.
What’s going on?
The free market is a straight-forward process. A willing buyer gets together with a willing seller to trade goods or services.
As long as no one tampers with the marketplace, everything works pretty much as it should. But it’s often hard for folks to resist making things “just a little bit better”. And then the government steps in to lend a helping hand…
First, the bad news: the free market isn’t really as free in the US as we like to think. Especially when it comes to oil.
There’s a whole bunch of government intervention at work. Our economy is more like a “mixed economy” - it’s partly free and partly highly regulated and government owned and controlled.
Left to its own, competition would naturally drive the price of gas rapidly downward - back to a buck a gallon that it sold for in the late 90’s. Maybe lower.
But whenever a legislature passes laws to manipulate a market (remember, they call it “helping”), they almost always come down on the side of the producers and against the consumers. Energy is the best example of this natural law at work.
There are 5 main reasons why gasoline seems so expensive –and may be headed down the road in California to $5 per gallon in the short run.
The cost of gasoline is the sum of these 5 items: crude oil cost, refinery costs, dealer & transport costs, taxes, and profit margin. Public policy permeates all aspects of this equation.
When either the supply is cut or held back artificially or the demand increases, the price shoots up. Sometimes, like today, both can happen simultaneously.
Take crude oil costs.
In 1999 a barrel of the benchmark Brent Crude Oil (LO, IPE) cost $10 to buy. Today, it sells for around $65.
The vast majority of the world’s oil is owned by OPEC - a producer cartel that would be illegal to operate in the United States. It consists of the giant government-owned oil companies of Saudi Arabia, Iran, Venezuela, Nigeria, Libya, etc., many of which are politically unstable - and unfriendly to the U.S.
OPEC is a supra-government-level price fixing system which sets output quotas to keep up the profits of the producers. Tiny producers like Exxon, Shell, BP & Total follow the prices set by the “big boys."
When demand is high, OPEC has pricing leverage over the marketplace. At a so-called “sunk” cost of $5 per barrel to pump the crude oil out of the ground, Saudi Arabia stands to make $60 per barrel profit. OPEC can hold back lots of oil from the marketplace and still make a profit for its governments.
In the USA, on the other hand, most cheap oil has already been extracted. It now costs over $25 per barrel - and is rising monthly.
The ability to tap most old and new oil fields inside the U.S. has been made illegal, and new “made in America” supplies have been forcefully held back. This has mostly been legislated in the reasonable public policy of a green ecology - and helped along by the kindly old oil companies, struggling to rebuild their depleted treasuries drained by the bad old days of $10 per barrel oil.
The bottom line: overall crude oil supply is presently limited - by fiat.
Overseas demand is soaring too, fueled by the millions of Chinese drivers who now have bucketfuls of dollars - which we eagerly ship them daily - to buy their own new cars.
Add in a few regional wars, oil field terrorist incidents and assorted natural disasters, and the overall global supply-demand balance has tipped toward a shortage of ready supply.
Up shoot the gas prices.
Add just 10% more domestic oil to the equation and the price of oil would likely crash below $20 per barrel.
A barrel of oil holds 42 gallons. This can be converted at the refinery into about 44 gallons of gasoline and other fuels & lubricants (so-called processing gains results from adding other chemicals to the mix). In theory, then, a gallon of crude oil is today worth roughly $1.55, or less, on the world’s markets.
Next, add in refinery costs.
Refinery costs (including delivery to the refinery by pipelines or ships) push the price up to about $2.25 per gallon of unleaded gas (RBOB ,NYMEX.)
This is an increase of 67%. Surely there’s a way to cut these costs?
Although gasoline usage has increased over 25% since 1975, there have been no new refineries built in the United States for over 30 years. The last refinery was started up in Garyville, Louisiana in 1976. US refineries are old, inefficient, and prone to breakdowns and frequent maintenance. And the blockbuster refineries are located in the energy-friendly but hurricane-prone states of Texas and Louisiana. They are running at maximum output.
The result? Many are off-line at any moment (lowering the production supply of gasoline). And we are now forced to import both crude oil and unleaded gasoline from outside the US. Domestic refineries are down to 89.5% utilization. We’re still recovering from fires and hurricanes that happened back in 2005 and 2006.
The solution is simple. Build more refineries. Right?
Wrong.
Both state and federal government laws, the dozens of environmental agencies, and green-movement lobbies coupled with a good dose of NIMBYism have effectively killed off the construction of modern oil refineries inside the United States for the past 3 decades. Demand goes up but domestic supply can’t easily be increased - especially when demand peaks over the summer driving season starting this Memorial Day.
In addition, there isn’t a single US gasoline. There are literally hundreds of "mixes," most mandated by law. Government edicts have forced additives like MTBE (which destroys the drinking water supplies) and less powerful but more expensive ethanol (which causes breathing problems) to be mixed into each modern gallon of gasoline. And each state can be different.
The result? Less real gasoline per gallon means less energy-per-gallon to power your car engine, and lower miles-per-gallon result. You have to use more gas to go the same distance. Which means the overall demand for our weakened gas goes up even more.
California is the worst culprit. The state has forced its in-state refineries to concoct a unique and expensive mix of gasoline sold nowhere else in the world. No more state refineries can be built.
As the California Energy Commission itself points out: “In fact, from 1985 to 1995, 10 California refineries closed, resulting in a 20 percent reduction in refining capacity. Further refinery closures are expected for small refineries with capacities of less than 50,000 barrels per day. The cost of complying with environmental regulations and low product prices will continue to make it difficult to continue operating older, less efficient refineries.”
And only a few refineries outside California are willing to expensively modify their non-California gasoline and ship it into California in any meaningful way.
The effect is obvious. Gasoline which sells for $3 a gallon in Washington, D.C. sells for $4 a gallon in San Francisco.
