The Myth of the Gas Price “Crisis”

Drivers, carmakers and oil companies will respond to the market

Once again, Americans are besieged by a crisis. You can’t turn on the cable news channels without hearing about “sky-high” gas prices and our “addiction” to foreign oil.

Sen. John McCain wants to suspend the gas tax. Sen. Barack Obama wants a “windfall profits tax” on oil companies. And both major political parties seem to support funding various programs to find alternatives.

But are high gas prices really a “crisis”?

“For many Americans there is no more pressing concern than the price of gas,” President Bush said at the White House on June 18th. “Congress must face a hard reality. Unless members are willing to accept gas prices at today’s painful levels or even higher, our nation must produce more oil.”

At its root, today’s gas prices reflect a simple market reality: the world pumps 85 billion barrels of oil out of the ground each day while the world wants to consume 87 billion barrels. Moreover, developing nations, primarily India and China, but also Brazil and eastern European countries, are growing rapidly, pushing long-term demand even higher.

It also doesn’t help that our capacity to pump and refine oil is stubbornly resistant to expansion. A new refinery hasn’t been built in the US since the 1970s.

Some of this inelasticity is economic-oil companies and refiners remember all too well the industry wide recession triggered by falling gas prices in the 1980s and 1990s after an equally severe price spike in the 1970s. Most of the inelasticity, however, is political-unrest in Nigeria and Iraq, saber rattling in Venezuela and Iran, or special interest opposition in the US and Western Europe.

So, in reality, today’s prices reflect the mismatch between supply and demand. The prices we face today, at the gas pump and on the world market, are really a normal and essential market outcome.

So what will we do? First, as in previous cases, we’ll cut down how much we drive. In fact, vehicle miles traveled, a common measure of demand, has fallen over the last year in the US.

Second, once we think the high prices will stay around for a while, we will begin to change how we get around. Fortunately, most of us won’t be forced to dramatically change our lifestyles. Simply dumping the SUV for a hybrid, four-door sedan essentially neutralizes the effect of the run up in gas prices over the last two years.

The more important step, however, will be long-term changes. That’s when, with the help of the profit motive, new kinds of vehicles will be available on a broad basis for consumers throughout the economy. That’s when we take advantage of an emergence of electric-only vehicles, perhaps even a version of the new Tesla sports car – currently over $100,000 for a car that goes about 220 miles per charge – will be priced low enough for the middle class. Honda has already launched the emissions-free, hydrogen fuel cell FCX Clarity for a limited run before going into mass production within 10 years. Drivers already have 20 different hybrid models to choose from. There should be 65 hybrid models by 2010.

While many working-class families will have to change their lifestyles or spending habits to deal with higher gas prices, most won’t. The median household income in the US is now $48,000 per year. Higher gas prices would be equivalent to about a 1 percent reduction in their total income at today’s prices. Most families will have the financial flexibility to make adjustments needed to accommodate higher prices.

As painful as it is for many, the correct response to high gas prices is to simply let the market work, not use them to justify billion dollar programs on inefficient fuel alternatives or adopt politically expedient gimmicks like a gas tax holiday. Market economies provide the natural incentives to both suppliers and consumers to ensure the needed adjustments will be made at the right time with the right technologies. We don’t need politicians or energy planners to trump market decisions.