Eddie Engles, 37, didn’t blink twice after he filled up his GMC Yukon at a gas station near downtown Chicago Tuesday. At $3.71 a gallon, the fill-up cost the clothing distributor $83.89. “That’s a new record. Every time I pump up, it’s a new record,” he said. Engles, who uses his SUV to haul his wares, said he has few options when it comes to cutting travel and gas expenses. “I just need it,” he said. “What am I going to do? Not fill up?”

The title says it all: High pump prices fail to alter driving habits. High gasoline prices have had little effect on American demand, which rose 2.5% in the first quarter of 2007. The average price was 3.221/gallon for regular unleaded on May 23rd according to that day’s AAA survey. The new price surpassed the inflation-adjusted record set in 1981. While demand remains strong, high prices are here to stay.

High gasoline prices result from an imbalance between supply and demand. The economists at the Federal Reserve Bank of Dallas give a succinct summary of why this disparity has occurred.

Pulling ahead of the gains in oil prices, U.S. retail gasoline prices have surged upward during the past two months—rising by about 70 cents per gallon to a recent high over $3 per gallon for regular unleaded. Higher crude oil prices, rising gasoline consumption in the first quarter (2.5 percent  over a year earlier), refinery outages and low levels of gasoline imports have pushed gasoline inventories sharply downward and prices upward.

Refinery utilization was also down because of the need to switch to the summer fuel blend. Gasoline stocks are now at dangerously low levels, but import levels picked up last week.

The EIA 2007 data shows the recent trend (graph, below left). Soaring gasoline prices have not been able to keep year-on-year demand flat, let alone decrease it. Economists define the price elasticity of demand (PE), which measures demand responses to changes in price.

PE = (% change in quantity demanded) / (% change in price)

A University of California (Davis) study by Jonathan E. Hughes, Christopher R. Knittel and Daniel Sperling, Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand, found that Gasoline_demand_5_11_07 American demand for gasoline is much less sensitive to price increases than it was in the 1970s. The study compared the price elasticity of demand (PE) for two comparable price periods, 1975-1980 and 2001-2006. The higher the PE, the more price influences consumer demand; for higher prices, it indicates larger decreases in consumption due to rising costs. The study found that the PE value for gasoline ranged from -0.034 to -0.077 during the period 2001-2006, compared to -0.21 to -0.34 for 1975-1980 – a decrease of a factor of almost 10. This result clearly shows that the effects of higher gasoline prices on demand in the 2001-2006 period were far less pronounced than during the 1970s, a disturbing trend that is reflected in the EIA’s 2007 data. It is not clear to what extent Americans can’t reduce consumption, as opposed to won’t.

Low price elasticity does not indicate zero demand response to higher gasoline prices. May demand growth has dropped to 1% over the same period in 2006. The Los Angeles Times’  State’s drivers are pumping less gas (April 13, 2007) reports that consumption in the Golden State decreased 0.7 percent in 2006 in response to sustained prices well over $3/gallon. This was the first such drop in 14 years. A USA Today analysis of Federal Highway Administration data indicates  that vehicle miles traveled (VMT) dropped 1.9% in February, 2007, compared to the previous year, but showed a 0.3% rise in March over the same month in 2006. Both months show a “sharp contrast to the average annual growth rate of 2.7% recorded from 1980 through 2005.” This VMT decrease — said to result, in part, from high gas prices expanded use of public transportation, and demographic shifts — would seem to belie the EIA gasoline consumption data and the price signal, unless fuel economy (miles per gallon) has slipped dramatically lately. Ethanol blends reduce mileage. Increased usage of this biofuel may explain the data discrepancy.

Price_behaviorWhere do gasoline prices have to be to put a serious dent in U.S. gasoline demand?  A USA Today opinion poll of price changing behaviors (link above, graphic left) attempts to gauge what the price must be before consumers will change their habits. In the vehicles category, 33% of respondents said that they would consider getting a more fuel-efficient vehicle at prices at or below $4.00/gallon. 41% said they wouldn’t switch vehicles at any price! SUV and light truck sales remain robust. Autodata Corporation’s April numbers indicate that purchases of all passenger vehicles declined 12.5%, while sales of the larger vehicles only dropped 2.9%. SUV and light truck sales made up 51% of all purchases. There’s more to this than meets the eye. Malcolm Gladwell’s Big and Bad: How the SUV ran over automotive safety (New Yorker, January 12, 2004) explains why SUVs give buyers an illusory feeling of safety, and why the number of cupholders is more important than gas mileage.

Us_gasoline_deficit_ogj In US gasoline markets to rebalance by 2010 (Oil & Gas Journal, Jan 15, 2007), Mike Wilcox, global head of downstream oil at Wood Mackenzie, examines how the U.S. gasoline deficit and demand trends will evolve in response to higher prices. It is not clear how Wilcox calculates the deficit, but it must be some estimation of the shortfall between consumption and domestic gasoline production which must be made up by imports or drawdowns on inventories. His analysis forecasts that the deficit will decrease after 2010, but is unspecified until then (graphic  left).

On the supply side, higher profit margins are supposed to attract additional investment in refinery capacity expansions. Wood Mackenzie’s global refining investment database shows many refinery add-ons in the works, including, for example, the 325,000 b/d expansion of Motiva’s Port Arthur, Texas facility. They believe most of these projects will be completed.


Wood Mackenzie reports that increased supply will be accompanied by slower demand growth as consumers eventually bow to higher prices (graphic left) — “In the short term, oil product consumption has remained surprisingly inelastic to price fluctuations. Wood Mackenzie maintains, however, that in the medium to long term, consumers will begin to respond.” Most of this response is supposed to come from greater average fuel efficiency —

Recent high pump prices have brought fuel economy into focus once more and sales of SUVs have faltered. Wood Mackenzie expects that the fleet’s fuel economy will gradually improve because motorists will seek more efficient cars and SUVs.

Some of this improvement will be mandated. Unchanged for a decade at 20.7 mpg, the light-truck fuel efficiency standard is now being increased progressively between 2005 and 2007 to 22.2 mpg. Hybrid sales will account for some of the efficiency gains due to increased sales, possibly 1 million vehicles by 2010.

Wood Mackenzie’s analysis describes a textbook economic response to the gasoline supply & demand imbalance. With regional gasoline prices between $3 and $4 per gallon, SUV purchases have not “faltered” yet. Inelastic demand has predominated, but the situation is unpredictable. Great price volatility in a tight market is now the rule, not the exception, for both gasoline and the oil upon which it depends. Spring and summer prices may spike far beyond current levels, provoking a dramatic drop in demand. Autumn and winter prices may fall to low levels as they did in 2006, providing an impetus for increased consumption. The anticipated rebalancing would also cut downstream profit margins. The large investments required to increase refining capacity make more financial sense if the strong demand growth trend is guaranteed to continue  — why would refiners kill the golden goose? An orderly transition to a more balanced market may not occur as Wilcox envisions.

The prognosis for near term gasoline prices is grim. The oil price will always be the main component determining refined product prices. The current premium on the gasoline price is due to the refinery bottleneck combined with low import levels. Even if U.S. gasoline consumption slows, and the market response boosts supply to fill the deficit, prices at the pump may remain high if the oil price continues to climb. As the Dallas Federal Reserve notes (link above) —

Overall market tightness has generally increased throughout the year because the growth of world oil consumption has been greater than the growth of oil production outside the Organization of Petroleum Exporting Countries (OPEC).

OPEC has resisted an increased call on its crude, and has no plans to meet again before September. President Mohammed al-Hamli has reiterated OPEC’s position that the market is in balance: “The market is very well supplied, in fact it is oversupplied. The problem is with the refining (sector) in the United States…they are not running at full capacity.” Al-Hamli’s statement diverts attention away from the rising oil price, which is now $65.50/barrel on the U.S. exchange (Nymex) and $70.49 in Europe (Brent). The potential for a disruptive hurricane in the Gulf of Mexico, combined with continuing instability in Nigeria and the Middle East, increases the oil price risks.

Memorial Day weekend kicks off the summer driving season as gasoline prices skyrocket. In the near term, demand is unlikely to soften if Americans follow their vacation plans. Dangerously low inventories make spot shortages and sudden, large price increases real possibilities. As they gas up their cars, Americans gripe about the costs and look for scapegoats. For now, people are filling up the tank anyway, and do not blame themselves. They are largely unaware of the risks, but most sense the truth — the days of happy motoring are gone.