September 4, 2014 | Backgrounder on Energy and Environment
Americans have become accustomed to high gasoline prices. For the past three years, the average price of regular gasoline in the U.S. has averaged above $3.00 per gallon. High gasoline prices not only hurt consumers at the pump, but also raise the costs of all goods and services that depend on transportation. Gasoline prices in the U.S. have dropped slowly over the past few months and are projected to continue to slide through the end of the year, despite increased unrest in the Middle East. Congress can and should do more to increase energy supplies domestically and to lower gasoline prices by opening energy markets and eliminating nonsensical policies that artificially drive prices higher.
Drivers recently received a bit of welcome news when the Energy Information Administration projected that gasoline prices would likely decline throughout the rest of 2014 to around $3.30 per gallon after reaching a high of $4 per gallon in March. For several years, paying more than $3.50 for a gallon of gasoline had been the new normal, and for many drivers that price is uncomfortably high.
High prices at the pump driven by market forces are not a compelling reason for the federal government to intervene in energy markets, but they should prompt policymakers to examine government policies that artificially increase gasoline prices. To that end, Congress and the Administration should implement policies that open access to domestic resources and reduce regulatory obstacles that prevent energy markets from working more efficiently.
Crude oil contributes the largest component to the price of gasoline. As of June 2014, crude prices made up 67 percent of the price of gas, with refining (14 percent), taxes (12 percent), and retailing and transportation (8 percent) accounting for the rest. The federal excise tax on gasoline is 18.4 cents per gallon and 24.4 cents per gallon on diesel fuel. States levy their own taxes, ranging from a low of 12.4 cents per gallon in Alaska to more than 52.6 cents per gallon in California.
Because oil is a globally traded commodity, different factors around the world affect the supply of and demand for oil, in turn affecting the price Americans pay at the gas pump. Growing demand for oil in other parts of the world, especially in rapidly developing regions such as India and China, put upward pressure on prices. Bad weather or geopolitical risks can disrupt supply, increasing prices. For instance, severe weather can shut down a pipeline or refinery, choking supply and driving prices higher.
Even the mere threat of such events can drive up prices because a potential supply disruption can affect oil futures markets. Speculators working in futures markets can increase the price of gasoline if inventories build up while sellers wait for higher prices, but that effect is marginal because companies must eventually offload those inventories. Too often when gas prices rise, politicians and critics of Wall Street blame speculators and allege market manipulation, but these criticisms are mistaken and unfounded. The Federal Trade Commission, the Federal Reserve, and others have thoroughly investigated allegations of speculator malfeasance and found no correlation between speculation and the price of any commodity. Importantly, speculators in futures markets can also drive down near-term prices on expectations of increases in supplies as well as provide liquidity and risk protection for both producers and consumers.
The value of the U.S. dollar also affects the price that drivers pay at the pump. Since oil is a global commodity and trades in U.S. dollars, when the dollar becomes weaker, more dollars are needed to buy the same amount of oil. For instance, when the Federal Reserve’s quantitative easing policies pumped money into the economy over the past few years, oil became more expensive for Americans. Conversely, when the dollar becomes stronger, such as during its recent 10-month high, a dollar can buy more oil.
Finally, global spare capacity also influences how quickly and significantly prices change. The Energy Information Administration defines spare capacity as the amount of oil that can be brought on the market within 30 days and sustained for 90 days. When oil markets are tight and have low spare capacity, the producers have less ability to respond by increasing supplies.
Additional U.S. oil production can significantly increase global spare capacity. Opponents of expanding domestic oil production argue that any increases in U.S. output will be offset by decreases in output from the Organization of the Petroleum Exporting Countries (OPEC). Consequently, higher American oil production will not affect gas prices.
Even though OPEC is often labeled a cartel, it does not necessarily act like one, nor has it ever been particularly effective in restricting oil supplies. OPEC is largely unable to restrict supplies and control oil prices because its members have a strong incentive to cheat and increase oil production above their quotas. As American University professor of international relations Jeff Colgan writes, “A cartel needs to set tough goals and meet them; OPEC sets easy goals and fails to meet even those.” Even if OPEC members were to restrict supply as U.S. production supplants OPEC supplies, global spare capacity would grow and provide a welcome cushion against any future disruptions.
In fact, all of these reasons have contributed in some degree to the recent fall in gasoline prices. Surging U.S. production and relatively weak demand have eased market concerns despite potential supply disruptions in the Middle East. As a result, futures prices are falling, which translates into lower prices at the pump, and the glut of supply is building the cushion of spare capacity.
The most effective response to variations in energy prices is simply to allow markets to work. Government restrictions, regulations, and attempts to force technologies into the market impede the free market’s efficacy. To help American fuel consumers, Congress and the Administration should:
High gas prices hurt consumers not only at the pump but also by raising the cost of all goods and services that depend on transportation. Higher prices mean families buy fewer goods and services, slowing economic growth and job creation. Congress should allow the market to determine prices by implementing the free-market reforms to improve the market’s ability to respond.—Nicolas D. Loris is Herbert and Joyce Morgan Fellow in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.
 Timothy Cama, “Gas Prices to Drop Through the End of 2014,” The Hill, August 12, 2014, http://thehill.com/policy/energy-environment/214946-gas-prices-to-drop-through-the-end-of-2014 (accessed August 18, 2014).
 AAA, “Gas Prices Continue to Slide Despite Geopolitical Tensions,” Daily Fuel Gauge Report, July 22, 2014, http://fuelgaugereport.aaa.com/gas-prices-continue-to-slide-despite-geopolitical-tensions/ (accessed August 21, 2014).
 U.S. Energy Information Administration, “Gasoline and Diesel Fuel Update,” July 7, 2014, http://www.eia.gov/petroleum/gasdiesel/ (accessed July 8, 2014). Figures do not total 100 percent because of rounding.
 Figures exclude the federal gas tax. American Petroleum Institute, “What’s Up with Gasoline Prices?” June 2014, http://www.api.org/~/media/Files/Oil-and-Natural-Gas/Gasoline/Whats-Up-With-Gasoline-Prices-HiRes.ashx (accessed August 21, 2014).
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 Angela Moon, “Shares Down as Wall Street Tumbles; Dollar Adds to Monthly Gain,” Reuters, July 31, 2014, http://www.reuters.com/article/2014/07/31/us-markets-global-idUSKBN0G00DP20140731 (accessed August 21, 2014).
 U.S. Energy Information Administration, “What Drives Crude Oil Prices?” http://www.eia.gov/finance/markets/supply-opec.cfm (accessed July 8, 2014).
 The 12 major oil-producing nations of OPEC produced more than 40 percent of the world’s oil in 2013. Benoit Faucon, “OPEC Says Oil Production, Market Share Fell in 2013,” The Wall Street Journal, July 18, 2014, http://online.wsj.com/articles/opec-says-oil-production-market-share-fell-in-2013-1405682597 (accessed August 5, 2014).
 Jeff Colgan, “The Emperor Has No Clothes: The Limits of OPEC in the Global Oil Market,” Universität Heidelberg, September 13, 2012, http://www.uni-heidelberg.de/md/awi/peio/colgan_13.09.2012.pdf (accessed August 21, 2014).
 Lananh Nguyen, “OPEC Spare Capacity to Surge amid U.S. Shale Boost, IEA Says,” Bloomberg, May 14, 2013, http://www.bloomberg.com/news/2013-05-14/opec-spare-capacity-to-surge-amid-u-s-shale-boost-iea-says.html (accessed August 6, 2014).
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 Natasha Doff and Naomi Chase, “Frozen East Coast Pays as Law Blocks Cheaper Fuel Flows,” Bloomberg, February 28, 2014, http://www.bloomberg.com/news/2014-02-28/frozen-east-coast-pays-as-law-blocks-cheaper-fuel-flows.htm (August 7, 2014). The full report is available for purchase from the International Energy Agency.