Cheap Gas Blues

Retail gasoline prices dropped another 8 cents last week, bringing the national average price down to $2.16/gallon. It seems strange to consider the prospect that gasoline might be getting too cheap, after seeing $3.00/gallon last summer, when consumers feared that lower prices might never return. Detroit seems worried about this, though, as the Big 3 ponder investments in expensive fuel efficiency technology and the President moots tougher Corporate Average Fuel Economy (CAFE) standards for passenger cars. As I pointed out in my comments yesterday on the State of the Union address, higher CAFEs won't ensure that more efficient cars will sell; all they will do is put them on dealers' lots. Detroit has just paid a heavy price for having mostly big SUVs on those lots when gas prices soared; how eager will they be to risk the reverse situation? This is a legitimate concern, even if crude prices don't drop any further.

The media and the public have generally linked recent high gasoline prices to the tremendous run-up in crude oil prices that occurred in the first half of 2006, capping a three-year trend. This was the stuff of newspaper headlines and graphics on the evening news for week after week in much of the past year. But that story missed another big influence, which was particularly noticeable following the hurricanes of the previous summer: the role of tight refining capacity and high refining margins in amplifying the impact of the oil price spike at the pump. The easing of this factor has also played a role, as high gasoline prices have unraveled.

The refining industry has historically been its own worst enemy when it comes to margins. Periods of good margins have typically prompted large new capacity investments, which expand refined product supply and dampen prices. Even without those large investments, refineries are subject to the phenomenon of "capacity creep", in which most facilities generally add about 1% of effective capacity annually, as a result of the continuous effort of engineers and managers to improve efficiency and remove bottlenecks. In a good year for refiners, demand for their products grows by more than this amount and margins stay healthy. In a normal year, the two factors keep pace. In a bad stretch, capacity can outgrow demand for several years in a row, and margins get stuck in the doldrums.

Looking at the difference between the traded prices of gasoline and crude oil on the New York Mercantile Exchange (the so-called "gas crack spread") as a proxy for US refining margins (ignoring the impact of diesel fuel and other products, as well as regional differences and seasonal variations in yield) we see that from 1991 through 2006 wholesale gasoline sold for $6.30/bbl over sweet crude, on average. That's a margin of 15 cents/gallon. However, during 2005-2006, that average was $9.76/bbl, or 23 cents/gal. But from March 1-August 7, 2006, when crude oil rose by $15/bbl to reach its peak of $78.42/bbl, the NYMEX gas crack--which in many years would have been squeezed between rising crude prices and resistant product prices--blew out to average almost 38 cents/gal. In other words, last spring and summer, increased refining margins accounted for nearly as much of the gasoline price increase as higher crude oil prices did. Right now, the gas crack spread is back to a more normal level of about 15 cents/gal.

Now throw biofuels into the mix. Whether or not expanded biofuels mandates are the answer to reducing our dependence on imported crude oil, they will likely have the unintended consequence of reducing gasoline prices by depressing refining margins. We've seen this effect before, in the early 1990s, when new environmental regulations forced refiners to incorporate up to 10% MTBE or ethanol in their gasoline blends in some regions, swelling the "gasoline pool" accordingly. The current growth in US ethanol production is adding the gasoline equivalent of a new medium-size oil refinery every year, and that pace would increase if the President's expanded biofuels mandate is enacted. Could this influx of non-oil-based gasoline blending component set up the refining industry for another period like 1992-94, when the NYMEX gas crack averaged under 10 cents/gal.? If so, it could usher in a sustained period of sub-$2.00/gal. gasoline for most of the country, even if crude oil remained above $50/bbl. The more biofuels enter the pool, the more pressure on gasoline prices, and market forces alone won't close this feedback loop.

This sounds like a classic case of good news/bad news. Many people would happily vote for more biofuels if they thought this would keep the fuel for their cars cheap. But cheap gas won't produce a groundswell of demand for highly fuel-efficient automobiles, such as hybrids that cost thousands of dollars more per vehicle. That means that our overall fuel consumption will continue to grow, even as we're trying to get the oil component of it under control, compounding our challenges in managing emissions and reducing imports. So before the federal government adopts a 35 billion gallon/year biofuel target, it should consider how to manage the accompanying unintended consequences.