Cullen Goenner discusses unleaded gasoline prices Editor’s Note: Unleaded gasoline prices have risen about 50 cents here in the Midwest from December 2006 through April of 2007. The U.S. average price of gasoline was $2.29 in early December, 2006, and is up to around $2.80 as of April 16, compared with an inflation-adjusted $1.85/gallon in 1970 and $3.05 in 1980. The recent run-up in gasoline prices at the pump is similar to what we saw last spring, when prices rose from $2.15 to $2.68 during the same period. Most of us put up and pay up at the pump, but University of North Dakota economist Cullen Goenner, who teaches in the College of Business and Public Administration, takes a hard look behind the numbers. A year ago in this space, Goenner correctly predicted both direction and magnitude of gasoline price advances, and he foresaw a late summer price decline. Office of University Relations writer Juan Miguel Pedraza talks with Goenner for his 2007 analysis of the fuel market situation. OUR: Gas prices are going up again, at just about the same clip they did a year ago. What's behind this year’s run-up and what do you see for the 2007 summer driving season? Goenner: One big difference this year’s rise in gasoline prices and last year’s is that the sharp increase in price occurred about a month earlier this year compared to last (February vs. March) while the spot, or cash, price of crude is currently about $2 a barrel less. The quicker run-up in prices is tied, in part, to increased tensions with Iran, which has promised to continue the enrichment of uranium, and a sharp decline in temperature that put pressure on heating oil prices. However, part of the increase (10 to 20 cents/gallon) is expected with the change of seasons as more Americans take to the roads for the summer vacation season. Predictions by the U.S. Energy Information Administration suggest that oil prices will stabilize around $65 a barrel this summer and gas prices will average $2.84 a gallon. OUR: OPEC—despite the war in Iraq and international tensions over Iran’s nuclear program—promises to keep pumping oil. Do you sense any danger of OPEC substantially reducing or choking off the flow of crude to the West? OPEC—the Organization of Petroleum Exporting Countries, the cartel that controls most of the world’s crude oil supplies—at its most recent meeting in March decided against further production cuts, as the price of oil strengthened from a low of $51 per barrel in January to around $60 in March. Nigeria is expected to increase production as is Saudi Arabia. OPEC also predicts that production by non-OPEC members will increase by 1.2 million barrels a day in 2007 over last year’s production. OPEC recognizes that stable oil prices are a key to global economic growth, which increases the demand for their product. Of greater concern than the supply of oil is the ability of refineries to meet the demand for gasoline. In the past, the US has had excess refinery capacity, but as demand has recently grown, the utilization rate of refineries has risen. Any unexpected changes in their operations, such as those which occurred after hurricanes Rita and Katrina, will cause huge problems. Currently, planned and unplanned refinery outages have led to a decrease in the stock of finished gasoline. OUR: Ethanol prices seem to be directly pegged to the price of oil--that is, they vary directly as price per barrel of crude changes. What’ the reason for this? Goenner: A study by Iowa State researchers indicates that the correlation between the price of ethanol and unleaded gas is 0.64, which indicates that their prices move together over time. Ethanol is primarily used as an oxygenate to help unleaded gas burn cleaner and thus the two goods are complementary. The demand and supply of ethanol and unleaded gas determine their prices. Factors that increase the demand for gasoline and thus its price, similarly affect the demand for ethanol and its price. OUR: What is the overall relationship between the price of crude oil and America's economy? Goenner: Higher oil prices contribute to two significant economic concerns; inflation and recession. An increase in oil prices contributes to a higher price level as gasoline prices and transportation costs of other goods and services increase, which are part of the basket of goods in the CPI. Inflationary pressure forces the Federal Reserve to consider raising interest rates that slow the economy in order to maintain price stability. Studies by the US Energy Information Agency suggest that every 10% increase in oil prices lowers US growth by as much as .1% from its expected growth rate. So if the economy is predicted to grow at 4.3% annually when the price of oil is $50 a barrel, then the economy would grow at a rate of 3.9% if the price were instead $70. OUR: What long-term negative consequences have resulted since the price of crude went from $50 to $70/bbl? What consequences can we expect in the future? Any positive outcomes? Goenner: If oil prices continue to be high, then we can expect an increased investment in research and development of alternative technology. American entrepreneurs, who lead the world in innovation, stand to benefit enormously from these opportunities, similar to those who benefited from the internet revolution. OUR: Most of us in the Baby Boom generation remember OPEC’s oil embargo of 1973, when petroleum prices quadrupled and the world economy spun into a severe recession and massive inflation. We also remember Detroit promising more fuel efficient cars. However, most of today’s cars, including many Hondas, have not increased mile-per-gallon performance. In fact, many have seen their average mpg retreat. Moreover, we've seen in the last 20 years a sharp increase in the number of large fuel-inefficient vehicles on the road. What’s the economic reason behind this seemingly illogical response to a very clear example of what happens when oil supplies shrink? Goenner: Gasoline prices actually rose more dramatically in the wake of the second oil shock (1979), where the average annual gas price rose from $2.39 (real 2006 dollars) in 1979 to $3.05 in 1980 and 1981. Prices during the summer of 2006 again broke the $3 mark, and the growth in the demand for gasoline slowed. Demand for gasoline is very inelastic, which means it is difficult for consumers to significantly substitute its use in the short run. If gasoline were to remain above $3 for a prolonged period of time, then we would see increased consumer interest in more fuel efficient vehicles. Consumers have chosen to purchase large fuel inefficient vehicles because they like the utility obtained from their size, perceived safety, and horsepower relative to the possibility of having to temporarily pay 25 percent more for the price of fuel.