Oil and Gas Prices: Something to Worry About?

Released: 6/29/00

If you have driven a car in the past few months, you may have made an interesting observation about the prices of oil and gas: they're high, really high.  Among those hardest hit are people in the mid-west and the west, where the price of a gallon of gas costs over two dollars.  Thus, consumers have become extremely (and quite understandably) uneasy.  The media has failed to comfort outraged consumers, but from the point of view of an economist, the story isn't so bad.

So where did these high oil and gas prices come from anyway?  There are many reasons.  The months before summer -- March, April, and May -- are ideal months for oil and gas companies to stockpile to prepare for the summer driving season.  Unfortunately, the shortage of oil during those months effectively drove up the cost of oil, preventing companies from building very large inventories.  As a result, oil and gas companies have fewer reserves now than they anticipated, which puts upward pressure on the price of gas and oil.  But the high price is as much a demand phenomenon as it is a supply phenomenon.  As we all know, summer is the peak driving season, and suppliers have been unable to match the increased demand for oil and gas.

Thus the high oil and gas prices.

But what the media and most consumers overlook is a point that an economist would never overlook: the difference between nominal and real.  True, we have not seen such consistently high oil prices since the oil crisis of the late 70s, but real oil prices are no where near what they were during the oil crisis.  The figure below is a graph of the real price of oil adjusted to 1947 dollars using CPI.

We can make a few noteworthy observations from this figure.  P2, the highest real price in this series, is at $10.50 per barrel.  P1, the real current price, is at $3.61 per barrel -- approximately 1/3 of P2.  One-third (?!?).  Can you imagine going to the gas station and seeing prices as high as $5-6 dollars a gallon?  Americans during the 70s could.  The truth is, most people have seen higher gas prices.  In fact, since 1980, the real price of oil has been higher than it currently is 37% of the time -- hardly a rare occurrence.

Even if the price of gas is rising, energy as a whole is declining, according to the energy CPI index (BLS), which posted two consecutive losses of 1.9% in April and May.  The figure below demonstrates this point.

Still others are worried about the effects of high oil and gas prices on industry.  Oil and gas are major inputs in several industries, especially in the manufacturing sector, and increased resource prices means increased prices for finished goods.  But May's CPI figure seems to indicate otherwise, posting a meager 0.1% gain.  In other words, the rise in the price of gas and oil has not caused a significant increase in the rate of inflation.  There are several plausible explanations for this.  Large productivity gains in the past few years (see Productivity: Here Today, Gone Tomorrow?) have made all producers more efficient users of oil and gas.  Therefore, less oil and gas are needed to produce the same amount of output, meaning that increases in oil and gas prices have a smaller impact on the price of the finished product.  According to Barron's, oil accounted for 8% of GDP during the 70s, but currently only accounts for only 1-2%.  Furthermore, the competitive nature of today's economy has prevented companies from raising the price of their products.  Instead of raising the price of their goods, producers are forced the eat the increased costs of production in decreased profits.

But, alas, the high price of gas and oil is not entirely bad.  Economies of the Southwest (Texas in particular), which depend significantly on the refining industry, thrive during times of high oil and gas prices.  The number of rotary rigs in Texas have been steady increasing at rates consistently above 5.5% a month since April.  Personal income in Texas rose 1.9% during April.  Unemployment in Texas has gone as low as 4.4%, the lowest since 1979.  Inflation has also managed to remain very tame, with CPI in the Dallas/Fort Worth area increasing a meager 0.1% in May.

Finally, the uproar over high prices has caused oil and gas to become a political issue.  Vice President Al Gore recently announced his plan to embark upon a multi-million dollar campaign to lower energy prices.  This plan would invest a portion of the budget surplus in energy and encourage consumers to be more fuel-efficient through tax incentives.  Meanwhile, several mid-west senators -- Peter Fitzgerald of Illinois and Kay Bailey Hutchinson of Texas -- are calling for a decrease on the federal tax on gas in order to gain a political edge with voters.  As long as oil and gas prices continue to be a political issue as it has recently become, there will be continued downward pressure on oil and gas.

Furthermore, OPEC again decided to boost production in its June 21st meeting by more than 700,000 barrels a day.  This added supply of oil will surely put even more downward pressure on the price of oil and gas.

See?  The situation isn't as bad as it seems after all, does it?

-Roger Kuo
Economic Analyst
theshortrun.com

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