Tuesday, July 29, 2008

The markets for gas and oil 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 makes and thus worth considering in 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.

Cross-posted at Outside the Beltway.

(Afterthought: Just after posting this I realize some might think I'm predicting $2 gas myself. That's not the point; the point is the plan laid out has the capacity to create a $2 price all other things equal. To actually make that forecast would require a whole lot more analysis than offered here. I don't wish to denigrate the efforts of EIA with its annual energy outlook -- just that using it to talk about prices 12 years hence is bound to be fraught with the very difficulties I used here to dismiss Gaertner's use of it. Error bands expand the further into the future you forecast.)

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