Gas Prices Demystified
Why you're paying so much, and why you could soon be paying less.
By Doug Newcomb

Filling up at the pump has become such a pain in the pocketbook that for the first time ever, gasoline consumption in the U.S. has stopped increasing. But even though America's consumption has been virtually flat for the past five years, prices in that same period have nearly doubled, with crude oil recently hitting record highs.

While commodity prices typically decline along with demand, gas has defied these market fundamentals. But the forces behind ever-escalating prices at the pump aren't a mystery once you look at the big picture — and the good news is relief may be just down the road.

The Crude Truth
The price of crude oil accounts for up to 70 percent of what drivers ultimately pay for gas at the pump, according to the U.S. Energy Information Administration. So with crude prices recently cresting at over $110 per barrel, you don't have to be an economist to calculate why gas prices have also hit record levels.

Like any commodity, crude oil prices are governed by the laws of supply and demand, but they are also affected by market speculation. While oil industry analysts disagree on which of these two forces exerts a greater influence on oil prices, the "fundamentals" of supply and demand present an unambiguous picture of why gas prices keep on rising even though we haven't been buying as much.


On the supply side, the Organization of Petroleum Export Countries (OPEC), which controls around 40 percent of worldwide crude oil production, exerts significant influence on supply by setting strict production limits for its members.

But Bob Tippee, editor of the petroleum industry trade magazine Oil & Gas Journal, notes that OPEC has limited ability to increase supply and therefore decrease prices. "The only way OPEC could bring prices down is to increase production," he says, "but it doesn't have much room to do that. They are pretty much at practical capacity limits now. "

With an already tight oil supply, unpredictable elements such as political unrest and weather also adversely affect production and ultimately gas prices. Turmoil in the oil-rich Persian Gulf invariably pushes oil prices higher, for example, as do natural disasters such as Hurricane Katrina, which battered the epicenter of U.S. oil production along the Gulf Coast in 2005.

And while U.S. demand has leveled off, the world's oil appetite has grown substantially. "Over the last several years, global demand has increased much faster than supply," notes Douglas MacIntyre, a senior oil analyst with the Energy Information Administration.

"In 2003, total international oil consumption was 79.6 million barrels, and that jumped to 85.7 in 2007. What we've seen and expect to continue," MacIntyre adds, "is that growth in demand — particularly in China, India and the Middle East — will be much faster than in the U.S."


Irrational Exuberance
Tom Kloza, chief analyst of the Oil Price Information Service, says the recent run-up in oil prices is due more to speculation in the commodities market than to supply shortages and the growing economies and populations in Asia. "The EIA has been steadfast in saying that it's all about supply and demand, but I disagree," Kloza contends.

"It's not the demand from average Joes, but demand from hedge funds, banks, commodities pools and so forth that's responsible for taking crude oil from $70 to $110 a barrel. There are a lot of huge funds that are invested in commodities, and one of their favorites is crude oil.

"I estimate that there's about $25 billion in oil futures — and that's $25 billion speculating on a higher price right now than a lower price," Kloza adds. "I think you'll find a lot of people in the oil industry will agree, and they're not going to complain if Wall Street is carrying the water for them. They've been the beneficiaries of that irrational exuberance."

Like many who follow the oil industry, Kloza believes that the price of crude oil is "overheated" and due for a correction.

"I compare it to the housing market a few years ago," he says. "It's been lifted by the sentiment that the oil market is a place where you can't lose money and values will move up higher and higher every year. But I think we'll see less of a bubble burst and more of a letting the pressure out like we've seen in the housing market. It could be a template for what we'll see in oil."

The EIA's MacIntyre agrees and says crude oil prices will be softened by new production streams. But he predicts prices will rise before they lower, mainly due to seasonal demand this spring, when pump prices traditionally shoot up as predictably as May flowers.

"Along with many other analysts, we've been expecting crude oil prices to decline for many months, and they keep going up," he says. "In March they were down considerably, but the expectation is not just that the price will slow demand a bit more, but that a lot of non-OPEC production that has been delayed will catch up to us later this year and next year. And as the market starts proceeding with that production, prices will start dropping."

"From what I hear, oil companies are investing based on $55 to $75 a barrel oil," says Tippee. "Historically, that's still pretty valuable oil. But I think that's what we'll see and gas prices will come down. But the big question is when."

Wait for the Fall
Just don't expect to see any dramatic price drops until well after the summer driving season, MacIntyre warns. "We expect gas prices to increase and peak nationally somewhere around $3.50 a gallon," he says. But consumers could see some relief by the end of 2008 and into 2009 as new production comes online.

"A couple of things are going to work in the favor of a more temperate price of gasoline down the road," adds Kloza. "Ethanol is going to displace a lot of the demand for gasoline because it's going to take 10 percent of gasoline out of the formula and replace it nearly everywhere east of the Mississippi this year. The second thing is prices won't be up a spectacular amount from previous years; it may be up a percentage point or so. But this is not the start of the $4- to $5[-dollar-a gallon] apocalypse for gasoline."

For instance, in 2004 Exxon Mobil earned more money -- $25.33 billion -- than any other company on the Fortune 500 list of largest corporations. But by another measure of profitability, gross profit margin, it ranked No. 127.