Gasoline prices will stay below $3

Peter S Magnusson ♦ October 19, 2008 ♦ 3 Comments

Yours truly not only correctly predicts that the price of gasoline will fall, but that it will stay below $3 for the foreseeable future, for some fundamental reasons.

I’m thinking of buying a big SUV for when I can’t fit everybody into my little car. I figure everybody else is scared of high gasoline prices, so the prices on trucks and SUVs ought to be decent right about now.

And yeah, they are. If you have an Excursion (diesel plz) that you want to sell, let me know.

The problem is, naturally, the mileage. MPG for a Ford Excursion on the freeway with a bunch of friends and kids and gear is about 15 (anecdotally). Best-in-class modern SUVs are at about 25, so that’s a loss of 10 mpg. Let’s say I drive it as my secondary vehicle, say, 3000 miles per year. So that’s 200 gallons for an old Excursion versus 120 for a modern, fuel-efficient SUV. So big boy has a 80 gallon per year handicap. That’s about $250 per year. A new, fuel-efficient SUV that seats a bunch of people is about $25-30K. A 5-year-old Excursion is under $10K. So for an investment of $15-20K I’m saving $0.25K per year. Not very interesting.

But, you say, gasoline will keep getting more expensive, won’t it?

Nope, it won’t. In fact, I’ll “betcha” that it will hold (inflation-adjusted) steady below $3.50 for the foreseeable future, and I’m pretty sure it will stay below $3, where it’s headed now.

Gasoline comes from oil, no surprise there. Though a barrel of oil is 42 gallons, only about 19 gallons of gasoline is produced during refining – the rest includes diesel (about 9 gallons), jet fuels (about 4 gallons), heating oil (about 2 gallons), and another 10 gallons of assorted products (yes, there is about a 5% expansion in aggregate). Now these resulting products complicate the demand side of the pricing equation, since they cater to related, but different, markets. On the cost side, there’s also refining, distribution, and taxes.

Despite these complications, and various bogus theories online notwithstanding, the empirical data fit an embarrassingly simple model. Basically, divide the price of crude by 45 and add a dollar and change. I couldn’t find a good diagram, so I downloaded government data and did my own analysis of the 1978 to 2007 range. These are annualized, inflation-adjusted numbers:

Gasoline and oil prices since 1978

These empirical numbers fit our simple theoretical model for how gasoline is produced quite well; essentially, the market is pricing all gallons (regardless of specific product) coming out of a refinery pretty much the same. Since a barrel of oil produces 44 gallons of product, you divide by something close to 44. It will vary around 44 depending on the market value of gasoline compared to the (weighted) average price of the other products, which apparently, over a long time frame, averages to be slightly more valuable than gasoline.

In the diagram, the (right) scale for gasoline is adjusted accordingly. I don’t need to quote any statistics for the correlation to be evident.

We can also see the price shock being created by the refinery bottleneck in the last several years, and we can now quantify it: we paid about $0.30 more per gallon in 2007 than we “should” if the market was in balance. Today, oil is trading at around $70, so prices at the pump “should” be around $2.70, which is why we’re seeing prices in several states going below $3. And they will keep falling not just because of crude oil prices, but the abnormal price premium should dissipate.

This all explains, by the way, why an oil man like Bush would disregard predictions of $4 gasoline. Given historical data, that would imply crude oil prices of $130. Indeed, spot prices hit those levels over the summer, going briefly above $140, but it’s fair to say that going to $130 and on up caught most in the oil business off-guard.

So what will oil cost in the future? I’m no oil man, but it looks pretty clear that for the foreseeable future it will be south of $130. Consider the weekly (weighted) spot prices of crude from the EIA:

World spot prices

The spike to $140 doesn’t look like part of a long-term trend, but a classical supply shock. As things look now, oil back over $100 looks unlikely for a while. And that means gasoline will go back under $3.50 once the dust settles.

But there are much deeper reasons than just looking at the chart of spot prices to understand that oil prices will not go higher over the longer term.

When Wired in issue 13.12 had a look at what energy sources come online (economically speaking) as the price of oil rose, the highest category was “$70 and up”. They had put together the best overview that I’ve seen to date of alternative sources of energy that would be relevant for the transportation sector. I’ve summarized it below (apologies for the poor formatting), and translated the prices to at-the-pump equivalents:

The aggregate barrel-of-oil equivalent of these sources add up quickly, and some of the reserve estimates boggles the mind. Current world consumption is about 100 million barrels per day. Thus, a trillion barrels is about 25 years – coal-to-gas alone is 100 years, as are tar sands. A quadrillion is a lot more. And renewable is, well, even more.

So at about $2.70 per gallon and up (the steady-state equivalent of $70 oil), a plethora of alternatives open up.

Notably, electric cars are not one of them. By Wired’s estimate, both fuel cell and biodiesel – both of which are renewable – are economical well before plug-in hybrids are.

Hence my conclusion – gasoline will stay below $3 for the next few decades (adjusted for inflation).

I’m buying the Excursion.