Macroeconomist on high gas costs

Editor's note: Assistant professor Dr. Kevin McIntyre teaches macroeconomics at McDaniel College. He specializes in gas prices, financial markets and monetary policy.

Michele, Columbia: I read that we may have already used up half of the oil that exists in the world. What happens now?

Dr. McIntyre: First, no one knows for sure what total global oil reserves actually are, but half seems as good a number as any. Your question, however, touches on a very important issue, namely future energy sources.

I would point out that the world is not going to suddenly run out of oil at some future date; as global oil supplies dwindle and extraction costs and, thus, prices rise, existing substitute energy technologies will become more attractive and new technologies might be developed. For example, we might see a higher incidence of nuclear power (as in France), further development and increasing cost effectiveness of relatively expensive existing alternatives such as fuel cells, solar, and wind, and the discovery of new technologies like cold fusion.

And history suggests that the market will indeed find a way. For example, 17th-century England's primary fuel source was wood. Toward the end of century, the British Isles were considerably deforested, and the resulting pricing pressures on charcoal led to the development of the coking process and the transition to coal as a primary fuel source. (As an aside, if you ever visit the Scottish Highlands, you will see forests planted in neat rows, the result of subsequent replanting.)

A similar market process can be used to explain the transition from whale oil to kerosene as the primary lighting fuel in Europe and the Americas in the 19th century.

Tony J., Sykesville: I've never been able to find someone that could answer this. Not that it will matter with the cost what it is today, but where does the nine-tenths of a cent come from in posted costs? Thanks.

Dr. McIntyre: Nine-tenths of a cent pricing is a marketing scheme designed to make gas prices appear slightly lower. Seeing a price of, say, $2.799 per gallon must for some be more pleasant psychologically than seeing a price of $2.80. Personally, I think it's pretty silly.

John P., Catonsville: If gas prices are adjusted for inflation, are we paying more for gas than in the 1970s, 1980s or 1990s?

Dr. McIntyre: If current gas prices are sustained, yes. According to the Energy Information Administration and using the Consumer Price Index (CPI) to adjust for inflation, the average price of gas was $1.95 in the 1970s, $2.13 in the 1980s, and $1.46 in the 1990s. Sustained gas prices in the neighborhood of $3 a gallon would be an all-time high in both nominal and inflation-adjusted terms.

Here is an interesting bit of trivia for history buffs: When adjusted for inflation, average gas prices were higher in the early 20th century than they were during the 1970s and 1980s, periods that most of us associate with expensive gas. Gas prices in the roaring 1920s, for example, averaged more than $2.50 in current dollars and averaged more than $2 a gallon even during the deflationary years of the Great Depression. Indeed, it was not until the 1960s that gas prices were consistently observed below $2 a gallon in current terms.

Daniel, Millersville: How does a rise in [the cost of] a barrel of oil immediately transfer to a rise in the price of already-refined gas at the pump, given that the gas bought today was refined months [or] even a year earlier?

Dr. McIntyre: This is because all current prices to a certain degree reflect expectations of future prices. Here's an example: Suppose I anticipate an increase in gas prices, say, next week. In response, I (and a few million other people) attempt to save a few dollars by filling up our tanks right now. This increased demand, however, ends up putting upward pressure on gas prices before any tangible reason for higher prices manifests itself.

In this regard, the expectation of higher gas prices can sometimes be a self-fulfilling prophecy. Things like this tend to happen all the time in a lot of different markets; last year's Labor Day weekend gas frenzy is a great recent example.

Nina, Lanham: What is causing the sudden spike in gas prices?

Dr. McIntyre: It's the usual culprits: global demand for oil -- driven by the large and robust U.S. and Chinese economies -- outstripping production; a weakening dollar, making foreign imports -- including oil -- more expensive; the approach of the "summer driving season"; and geopolitical uncertainty in the Middle East, Venezuela and Nigeria, raising concerns about future oil production. I would also suspect that the beginning of another hurricane season is producing some oil-related jitters.

Donna, Monkton: I can understand if stations need to raise gas prices, but do they need to be done on a daily basis? You can see one price in the morning and another in the evening and yet another the next morning! I'm sure they are not buying gas daily and paying higher prices.

Dr. McIntyre: Retail gas markets tend to be very competitive. Margins for individual gas stations are quite slim, so any opportunity to raise prices will be acted upon immediately.

Similarly, the failure to quickly adjust prices downward will likely result in lost sales. This, coupled with the fact that gas prices reflect crude oil prices -- which are changing more or less continuously 24 hours a day -- means that regular and frequent changes in gas prices are normal and to be expected.

John Vitter, Glen Burnie: Maryland has a law that states that no one can sell gas below cost, which was passed by the Maryland legislature to protect independent gas station owners against high-volume sellers (Costco, Wal-Mart, Sheetz) pricing their gas below cost. In your opinion, does this law create an artificial barrier to gas prices in this state, and if this law was not on the books, would we see a decrease in gas prices brought about by the high-volume dealers pricing at or below cost?

Dr. McIntyre: Firms that engage in predatory pricing, that is, pricing below cost, do so in an attempt to drive competitors from the market, which in turn will result in more pricing power, and thus higher profits, in the long run. Accordingly, the Maryland law is, in theory, designed to protect not only smaller retailers, but also consumers.

Predatory pricing is illegal in the United States, falling under federal antitrust statutes. In the absence of legislation designed to prevent predatory pricing, it is certainly possible that we would see decreases in gasoline and probably other prices, but only in the short term. Firms cannot permanently sell at a loss.

Where this issue gets sticky is in the possibility that larger firms' unit costs may be lower than that of smaller firms because larger firms are in a better position to shop around at the wholesale level and may have more leverage to bargain for volume discounts and such from wholesalers. Thus, a large-volume gas retailer may be selling at cost, but on a per-gallon basis is charging a price less than that of a neighborhood gas station that is doing the exact same thing.

Carolyn Hicks, Joppa: Everyone is outraged by the high cost of gasoline -- it isn't cheap. But what about a little conservation here? Why do people insist on driving the gas guzzlers when the market rules? Supply and demand plays a big role. The more you want, the more it will cost you. Try downsizing and conserving.

Dr. McIntyre: I personally tend to agree. Over the past few years, there have been some very strong incentives to conserve on energy of all sorts; going forward, we will assuredly see a trend toward smaller vehicles, higher use of public transportation and so on. While market forces will influence our behavior in the long run, an unfortunate difficulty is that it is very costly for many individuals to effectively deal with higher energy prices in the short term. For example, trading cars, insulating homes, installing better windows, etc., represent very large expenditures for most of us.

The frustration many conservation-minded folks have with this is that the public seems to be myopic regarding energy prices. We know that energy prices can be extremely volatile, and most adults remember the difficulties created by high oil and gas prices in the 1970s and 1980s, yet all of this was apparently quickly forgotten in the 1990s, when energy prices were really cheap. That was the time when conservation would have been relatively painless.

A reader from Annapolis: Isn't it true that a temporary repeal of the gas tax wouldn't change the market-clearing price, but would simply redirect the 23.5 cents per gallon from government coffers to service station owners and oil companies (not that there's anything wrong with that)?

Dr. McIntyre: A repeal of the gas tax -- or any excise tax for that matter -- would cause the market price to fall. Although over time it is the case that the bulk of the gas tax burden is passed to consumers, gas retailers don't have enough market power to hang on to a 23.5-cent increase in their margin.

Dennis C. McGrath, Trenton, N.J.: Recognizing that this question really encompasses an enormity of variables, I will ask anyway: By what percentage amount would each American driver need to increase their personal vehicle's average [miles per gallon] so that gasoline demand flattens and price pressures diminish? I have heard it said that if everyone got a tuneup, inflated tires properly, slowed down and eliminated unnecessary travel, we could increase fuel economy 10 percent across the board and effectively drive gas prices back down. Naive, or brilliant?

Dr. McIntyre: Let me try to answer this question without really answering it. My intuition tells me that your 10 percent number is on the low side. Here's why: Gasoline prices are based on the price of crude oil, which is set in a global market, of which the United States is a big, but not singularly dominant, player.

Crude oil in turn has lots and lots of uses. In addition to automobile gasoline, crude oil is refined into jet fuel, kerosene and other fuels and is used in the production of other commodities such as plastics, asphalt and various lubricants. In fact, only about 20 percent of all crude oil used in the United States ends up as automobile gas.

The punchline here is that, assuming domestic gasoline demand falls by about the same amount, a 10 percent increase in fuel economy would not cause much of a dent in the world oil market.

Jim Baldridge, Baltimore: People who talk about such things describe the "volatility" of the market. We see prices jump up, and even down sometimes, throughout any given day. Is this just based on the "feelings" of stock market speculators?

Dr. McIntyre: Expectations play a very important role in financial and commodities markets. Indeed, traders' expectations of the future economic conditions are "priced in" to current asset and commodity prices. Day-to-day movements in prices occur when traders obtain new information and correct past mistakes.

What makes an expectation different from a "feeling" is that an expectation (in the economic sense) is based on relevant information appropriately interpreted. For example, suppose that the market expects that, sometime this fall, OPEC will expand their oil deliveries. Knowing all about supply and demand, the market will thus anticipate a drop in oil prices. In response to this, traders might begin selling oil shares today, before the price drops. This, in turn, will cause the actual price of oil to drop. This sort of thing happens every day, particularly in fast-moving markets such as the stock market and commodities markets.

Kate, New Windsor: I heard gas in Europe is $7 per gallon. Will we ever pay the same high gas prices that people in other countries pay?

Dr. McIntyre: International differences in gas prices are due primarily to differences in taxes. If gasoline is ever taxed in the United States at the same rates that it is in European countries, then yes. On the upside, the possibility of such a massive increase in gasoline taxes in the United States is virtually nil.

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