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Wednesday, June 08, 2011

Ranking the Causes for High Prices at the Pump

At a hearing on May 25, U.S. Rep. Jim Jordan, chairman of the Subcommittee on Regulatory Affairs, Stimulus Oversight and Government Spending of the House Oversight and Government Reform Committee, asked a group of economists to rank the causes of the recent increase in the price of gasoline.

That's an interesting question, and provides the opportunity to discard some off-base reasons and get focused on what matters most.

Let's start from the lowest rank, and graduate to the most important factors.

Last on the list is the idea of greedy, all-powerful oil companies. Indeed, this would not even be worth mentioning, but for the fact that a good number of people, including various elected officials (!), either buy into this conspiracy theory, or at least give it lip service for political advantage. All one has to do is look at the rise and fall of oil prices - along with oil company profits - over the years to understand that so-called "Big Oil" does not have the ability to control oil and gasoline markets.

Next up is the increase in global demand. The argument here is that increased economic growth around the globe generates more demand for oil, pushing up the price of oil and therefore the price of gasoline. Economics 101 shows that there is some legitimacy here. But demand cannot be viewed in a vacuum. A demand-driven quick and substantial price rise would indicate that this demand was unforeseen in the marketplace. That seems highly unlikely.

Of course, demand cannot be considered without looking at supply as well. And it is on the supply side of the oil equation where we get into more substantive factors impacting prices at the pump.

U.S. federal policies directed at domestic energy production certainly play a part - with some policies having an impact on prices in the short run and others more so over the longer haul. First, federal regulations and obstacles to deepwater drilling have been imposed by the Obama administration since the BP oil spill in the Gulf of Mexico. Second, keeping vast offshore and onshore energy resources clearly places upward pressure on oil prices. For example, 85% of U.S. offshore resources are off limits. Third, emerging EPA regulations on CO2 emissions have a negative effect on investment in the development of carbon-based energy sources, especially oil and coal.

At the top of this ranking finds two factors impacting prices.

The first top factor is uncertainty swirling around events in North Africa and the Middle East, which has added a substantial fear premium to the price of oil. As the EIA has reported, over a third of the world's liquid fuels are produced in the Middle East and North Africa. Indeed, even when matters seem to settle down for a short time in that area of the globe, the uncertainty persists as to what might come next.

The second top factor is Federal Reserve monetary policy. Since oil is priced in dollars, the value of the dollar and Fed monetary policy as it pertains to inflation and inflation expectations play key roles in the price of oil and gas. The Federal Reserve has been running an expansive monetary policy since September 2008 that is without precedent. This has hit the dollar, boosted inflation, and serious concerns about where the dollar and inflation are headed.

In conclusion, it must be noted that gas prices have risen over the past two years during a period of recession and under-performing recovery. That reinforces the argument that the Middle East/North Africa and U.S. monetary policy are the top price drivers. The former also points to a critical need for more energy exploration and production at home, and the current Administration needs to wake up to this fact and make policy changes accordingly.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.

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