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Why Gas Prices Are Soaring

A Q&A with Dennis Jacobe, Ph.D., Gallup’s chief economist

Gallup's chief economist knows the cause -- and what those high prices are doing to the economy

Gas prices are up about 30% since the beginning of the year. In constant dollars, the cost of gasoline is higher than it was during the 1973-74 OPEC oil embargo, during the 1990 Iraqi invasion of Kuwait, and after the 9/11 attacks. Unless prices decline precipitously and soon, the cost of gas will be higher than it has ever been.

That's the piece that's really missing in the discussion of oil and gas prices, but particularly gas prices -- the whole notion of volatility.

We all know how happy that will make drivers. But what will it do to the economy? To investors? Will record-high gas prices hasten a recession? And really, why all of a sudden are we paying $3.00 and up for a gallon of gas?

Gallup Chief Economist Dennis Jacobe has been analyzing the situation and has come to some surprising conclusions. Among them are that higher gas prices are the result of myopic oil company business strategies, and the best government response might be a regressive gas tax. He also thinks none of this would be so painful if Americans remembered that everything that goes up must come down -- and vice versa.

Read on to discover who's to blame for your last $40 fill-up, whether you should put money in a "BioWillie" station, and how much worse this could get.

GMJ: Why did I just pay $3.00 for a gallon of gas?

Jacobe: That's a good question. The general economic argument would be that it's all an issue of supply and demand: The worldwide demand for oil keeps the price high, unrest in the Middle East decreases production, and a lack of refinery capacity in the United States boosts the price of gas even higher. Factor in the U.S. summer driving season and its changes in the gasoline formulas, and it reduces the ability of the refineries to produce. So all of those things make demand go up.

GMJ: But that doesn't make sense. Worldwide demand for oil has been growing steadily, which cannot be a surprise to the oil industry. Furthermore, any company that wants to make money will create the infrastructure to handle demand, such as building more refineries. And on top of that, gas prices always go up in the summer, but never by a dollar a gallon.

Jacobe: It's true that as gas prices go higher, public skepticism that the markets are working increases. There probably is some justification for that because the oil markets are essentially an oligopoly, and they have aspects of monopolistic pricing. Of course, OPEC is by its very existence a kind of collusive entity. And it's true that China and India have been growing rapidly, but their demand for oil products has increased more rapidly recently than it has in the past.

And, in a worldwide sense, international tensions create a difficult market environment, because supply is never a sure thing. There are problems in Nigeria that nobody knows how to estimate; the U.S. difficulties with Iran affect oil supply; Iraq's never returned to its pre-war levels of production; and OPEC controls the level of supply and basically attempts to set a minimum worldwide price. As to the refinery issue, the United States has very strong limitations on new refineries. We haven't built one in about 30 years.

There's also some history involved here. Over the long term, at various times, gas prices have gotten very high, then have gone back down and gotten very low again. That lack of price stability has made it difficult for companies to invest long term. In a worldwide sense, countries like China are out there buying oil long term, but U.S. companies don't necessarily take a long-term view; they tend to take a Wall-Street-driven quarterly view. So we're exploring for more gas and oil than we would when gas prices are lower, but because there's no long-term certainty about gas and oil prices, it's harder for people and companies in a free market environment to make those long-term investments.

GMJ: And we're all thinking quarter-to-quarter -- buying SUVs when gas prices are low and eyeing hybrids when prices are high.

Jacobe: That's the piece that's really missing in the discussion of oil and gas prices, but particularly gas prices -- the whole notion of volatility. Gas price volatility puts the consumer into a "negative expectations" mode. It's not just today's gas price of three dollars a gallon that's bothering the consumer; it's also the prospect that the price might climb to four dollars a gallon or more if we have another bad hurricane or any other significant refinery disruption. Uncertainty simply exacerbates the economic damage done by high gas prices.

That creates instability economically, but it also creates a problem for consumers who are deciding how to respond. Most consumers try to maintain their living standard despite short-term effects. Only when they become convinced that gas prices are no longer a short-term issue do they make major adjustments. So the volatility of gas prices creates a mindset that causes consumers to adjust less quickly than they would otherwise. For example, as prices went down late last year, then bottomed in December, people held on to their SUVs, thinking, "Boy, was I smart." Then by May, those same people were thinking, "Oh my goodness, what a mistake."

And once consumers finally decide to adjust their lifestyle to higher gas prices, that adjustment can take a long time. Commuters traveling 50 or even 100 miles a day to work and back can buy a new, more fuel-efficient car, but that can involve a significant investment. They can change jobs and work closer to home, but that involves getting a new job. They can move closer to their job, but that can be a major challenge given today's housing prices. (See "The Subprime Meltdown Will Burn Everyone" in the "See Also" area of this page.)

The one thing that government can do about high gas prices -- the one thing the law does allow -- is a lot of jawboning.

The lack of price stability at the pump also makes it hard for investors and companies to justify long-term projects to increase the supply of both gas and oil. They get really rich at this point in time, but it's uncertain whether there's an immediate return to plowing more money into the existing industry or even investing in alternative fuels. Given past history, they risk real financial difficulties if they base their investments on a high gas price and then gas prices plunge in the future.

GMJ: Meanwhile, what are rising gas prices doing to the U.S. economy?

Jacobe: Retailers have already been suffering this year, and gas prices are going to make it worse. I think what makes this current bout of high prices worse is that the U.S. economy is a lot slower than it was a year or two ago. As a result, higher gas prices are hitting at a time when the economy is weaker than when they hit in the past.

I think former Federal Reserve Chairman Alan Greenspan's prediction of a one-third probability of a recession is probably conservative. The only place where there is a rapid accumulation of wealth is on Wall Street. If the markets ever turn down, then that stimulus will also be gone.

Considering what's happening with gas prices, real estate, autos, and mortgage lending, the only real stimulus I see right now to consumer spending is the equity markets. So as long as the equity markets stay high, there's some hope that upper-income people will continue to spend. If there's a sharp downturn in the equity markets, then the recession prediction becomes even more significant.

But I think the real issue is: If consumers will try to maintain their living standards for awhile and gas prices stay high, will they pull back significantly? Will we then have a consumer-led recession? I think that's a real possibility, given everything that's hitting the consumer.

GMJ: How are consumers reacting right now?

Jacobe: In our latest UBS/Gallup Index of Investor Optimism poll, we asked people what they're paying for gas, if they expect gas prices to go even higher, and if so, what they plan to do. Fifty-one percent said they were going to cut back on their driving this summer. Forty-three percent said that they were going to cut back on vacations. Sixty percent said they were going to cut back on their other spending in general. (See "Investor Optimism Highest Since January" in the "See Also" area of this page.) So if gas prices stay high and don't start dropping sharply soon, then I think that the consumers will cut back.

GMJ: Can the U.S. government do anything about it?

Jacobe: I don't think the U.S. government can go out and intervene in the world oil and gas markets without making things worse, not better. The government could lower the federal excise tax on gasoline, as could the states, but this would provide only a relatively minor relief to drivers while adding to the deficit. Alternatively, the government could open the strategic oil reserves, but again, that would also provide only relatively limited oil price relief and even less in gas price reductions while leaving us with a reduced supply in case of a real emergency.

The one thing that government can do -- the one thing the law does allow -- is a lot of jawboning. When people on Capitol Hill get upset and talk about things like windfall profit taxes, which you're liable to hear again, that sort of jawboning makes oil companies and everyone associated with the gasoline market nervous. I think jawboning can be effective in mitigating gas prices to some extent simply because it would make market participants more aware of the potential for political risks involved when gas prices at the pump spike and reach new highs. But government jawboning has been used much more effectively in the past than it has during recent years.

My own view, however, is that what we ought to do is talk about stabilizing energy prices.

GMJ: How do you suggest we do that?

Jacobe: What people see is the cost of higher gas prices at the pump. But the real cost factor that seems to go unrecognized is that no one, from consumers to investors and businesses, can plan on any kind of stability in gas prices. Thus they can't, or anyway don't, plan ahead and make long-term investments, because they don't know if the reward will be there. So I believe that the government should be trying to figure out a way to help stabilize prices, perhaps by creating a new variable rate tax that goes up as gas prices go down and goes down as gas prices go up.

This strategy would probably be opposed by everybody who opposes new taxes. Worse yet, a new gasoline tax would be highly regressive, meaning it would hurt lower income consumers the most. Generally speaking, I include myself in the group that opposes new taxes, particularly regressive ones. Still, I think the goal of relative price stability in gas prices is in the public interest -- a real public good. Further, it is always possible to structure such a new gas tax in such a way that it is essentially revenue neutral, perhaps by increasing the low-income tax credit. Of course, another alternative would be to use the funding to subsidize alternative sources of energy.

Given commuter costs, does it make more sense to build smaller and bring the work closer to potential employees than it does to build bigger and need more people commuting long distances?

Whatever the shape of the effort, I think the goal of creating gas price stability is worthwhile. Then everybody could start making long-term decisions when it comes to future gas prices instead of short-term decisions surrounded by a lot of uncertainty. In essence, the idea is for the U.S. government to mitigate gas price volatility by utilizing federal tax policy. Something like this that tends to influence the demand for gasoline seems reasonable to me when you consider that OPEC is routinely colluding to control oil supplies and maintain high oil prices.

GMJ: Speaking of the demand for oil and gasoline, wouldn't the whole problem go away if the United States stopped being dependent on foreign oil?

Jacobe: Of course, energy independence is a terrific goal for the United States. The real issue is: How do we get there? The problem is that our government and our politics aren't really very good at what I think of as "transition economics." For example, if we as a nation really wanted to achieve energy independence, you would assume that the government would do everything possible to reach that goal: take strong actions to encourage conservation and simultaneously make every possible effort to increase production. Unfortunately, that hasn't happened over the past couple of decades, and it isn't likely to happen any time soon.

Just consider the tradeoffs we face between energy production and the environment. Earlier this year, Gallup asked the public whether development of U.S. energy supplies, such as, oil, gas, and coal, should be given priority even if the environment suffers to some extent. Only 34% of Americans supported this idea, while 58% supported just the reverse -- giving priority to the environment even at the risk of limiting the amount of energy supplies. In this regard, while 50% of the public supports expanding the use of nuclear energy, 46% oppose such an effort. So, while most Americans might support the idea of energy independence for our nation, there isn't really a political consensus about how we get there. (See "Public Favors Environment Protection Over Energy Production as Priority for U.S." and "Most Americans Back Curbs on Auto Emissions, Other Environmental Proposals" in the "See Also" area on this page.)

GMJ: So what you're saying is that we're stuck. The government policy is paralyzed because public opinion is split between the environment and energy production. And government can't take direct action to reduce oil prices or gas prices at the pump without making things worse. So, is there anything that can be done besides government jawboning?

Jacobe: Well, as I noted, efforts to reduce gas price volatility would be helpful but also difficult. So, no, I'm not optimistic that the government can or will help lower gas prices at the pump.

However, I do think private individuals and companies can do a lot more to help the situation by simply assuming that higher gas prices are here to stay as they make their individual decisions and plans for the future. Instead of just thinking about buying a car that gets good gas mileage, consumers might want to start thinking more broadly. For example, when looking for a job, potential employees should take into consideration commuting costs. It may be better to take a job closer to home at less money not only to reduce your commuting time, but also to have lower commuting costs, particularly if you assume they will remain high or go higher.

Similarly, when thinking about buying a house, consumers may want to think about more than its energy efficiency alone. Given its location, how much will it cost to get to work if gas prices remain high? How much will it cost to get to someplace to shop or to get the kids to school if gas prices go higher?

As far as companies are concerned, they may want to take a new look at their assumptions about economies of scale. Given commuter costs today and in the future, does it make more sense to build smaller and bring the work closer to potential employees than it does to build bigger and need more people commuting long distances? Similarly, should company managements re-evaluate the tradeoffs associated with telecommuting, given expected future energy prices?

My assertion would be that current gas price volatility is making it harder for private individuals and firms to make these kinds of energy-conscious long-term decisions. In this regard, it's time for the government to step in and create gas price stability. I say that even though I don't like government intervention, nor do I think government does most things well. But the situation has gotten that bad.

-- Interviewed by Jennifer Robison


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