Why are gasoline prices falling so rapidly?

As of October 29, 2001, the national average retail price of regular gasoline was $1.235 per gallon, its lowest level since November 8, 1999 (Figure 1). The average price has fallen 29 cents in 6 weeks since September 17, with further declines perhaps to come. The sharpest decline has been in the Midwest (Petroleum Administration for Defense District 2), where the average has dropped 57 cents in 8 weeks since Labor Day (September 3). Additionally, this decline comes on the heels of a 33-cent drop in the national average in 10 weeks from Memorial Day through August 6, interrupted only by a brief 17-cent rise in August. In total, the national average retail gasoline price has fallen nearly 48 cents from its peak on May 14. This is already the widest one-year range in retail prices since EIA began its weekly survey in 1990, and it=s all occurred in the past 5 months.

Although U.S. consumers are undoubtedly pleased at this reduction in driving costs, many are puzzled at the speed and magnitude of the decrease, and wonder when gasoline prices will rise again, and whether they will increase as quickly as they have recently fallen. While the Energy Information Administration (EIA) can=t predict with certainty what the future may hold, there are a number of factors behind gasoline prices that can help to explain this year=s rapid price changes, and may in turn give us some indications about which way they will go next.

Figure 1. Crude Oil and Gasoline Prices Graph. If you need assistance viewing this page, please call (202) 586-8800.

Major Gasoline Price Drivers

The first step is to understand what drives gasoline prices. As explained in EIA=s brochure A Primer on Gasoline Prices, there are three main factors that influence price fluctuations for gasoline (and for that matter, for most other petroleum products):

$ Changes in crude oil prices - generally speaking, any change in the underlying price of crude oil is passed through to the prices of refined products, though these changes are sometimes offset by other factors described below. After peaking about a year ago at their highest levels since the Gulf War, world crude oil prices have declined over the past 12 months, as weakening global demand has allowed inventories to recover from relatively low levels seen in 2000. Although crude oil prices are now near their lowest levels in 2 years, their total decline of $8.68 per barrel (for West Texas Intermediate) from mid-May to mid-October represents only 21 cents per gallon, or less than half the decline in retail gasoline prices over the same period.

$ Seasonality in the gasoline supply/demand balance - gasoline demand is significantly (about a million barrels per day) higher at its summer peak than at its low point for the year, typically in January. Domestic refinery production of gasoline is also seasonal, but with somewhat less variability and slightly different timing, leaving a larger portion of summer demand to be satisfied by imports and withdrawals from inventories. Typically, after subtracting out crude oil prices, gasoline prices average about 10 cents per gallon higher at their summer high than their winter low.

$ Unusual events or trends affecting the supply/demand balance - these can include problems affecting supply, such as a refinery or pipeline problem, or demand, including changes in the specifications of products that can be sold in a particular region or season. This type of influence has come prominently into play in the past several years, particularly in the Midwest and in California. In the past several months, demand has been impacted by a weakening economy, while potential refinery gasoline production has increased slightly due to a drop in jet fuel demand following the September 11 terrorist attacks. In fact, with the portion of the gasoline price change since May attributable to crude oil prices and seasonal factors accounting for no more than 30 cents per gallon, about another 18 cents must be ascribed to such Aunusual@ factors.

These three major factors explain most overall changes in gasoline prices; however, these influences are not reflected at all market levels simultaneously. EIA analysis has shown that a given change in the spot market price for gasoline is transmitted, over a period of several weeks, to the retail market. As such, after an extended rise or fall in wholesale prices, retail prices may continue in the same direction for as much as a few weeks before fully reflecting the most recent shift in wholesale markets. While the influence of declining crude oil prices and weakening demand since this summer has been quickly reflected in spot and futures prices, EIA modeling suggests that as much as 5 to 10 cents of these wholesale price decreases have yet to be passed through to the retail level. Thus, depending upon market events during the next few weeks, EIA would expect further moderate decreases in U.S. average retail gasoline prices.

Regional Considerations

A look at regional differences in U.S. gasoline prices (Figure 2) helps to isolate the impact of the third factor described above. While crude oil prices and seasonal variations should be fairly consistent across all regions, unusual supply or demand fluctuations should, by definition, be most pronounced in the particular area affected. If this is the case, we would expect price changes in regions relatively unaffected by unusual conditions to be near the 30-cent decline attributable to the first two factors above. In fact, retail gasoline price declines since mid-May in the East Coast, Gulf Coast, and Rocky Mountain regions have ranged from 30 to 43 cents per gallon. In California, where average regular gasoline prices had neared $2 per gallon in the spring, the decline since then has totaled 48 cents per gallon. However, in the Midwest, which has seen three price spikes in the past two years, prices have fallen more than 60 cents per gallon since mid-May.

Figure 2. U.S. Retail Regular Gasoline Prices, by Region Graph. If you need assistance viewing this page, please call (202) 586-8800.

Determining the cause of this year=s summer/fall gasoline price decline, then, appears to be largely a matter of explaining the unusually sharp drops in the Midwest, and to a lesser extent California, along with less than 10 cents of the decreases elsewhere in the United States. In the case of the Midwest, in particular, it is helpful to look at the Atypical@ relationship between prices in the region and those elsewhere in the country. Since PADD 2 produces about 80 percent of its gasoline at local refineries, and receives most of the remainder from the Gulf Coast (PADD 3), the relationship between prices in these two regions can be a useful barometer of the supply/demand balance in the

Midwest. Over the past several years, with the exception of the price spikes the past two springs and in August of this year, retail gasoline prices in the Midwest have typically averaged from 0 to 10 cents higher than those on the Gulf Coast. When Midwest gasoline prices have spiked, they have reached differentials of 23 to 36 cents above Gulf Coast prices. In the most recent decline, Midwest gasoline prices have fallen from 35 cents higher than the Gulf Coast on Labor Day to virtually equal in the past three weeks. Thus, it is reasonable to conclude that it was the high prices seen in the Midwest in May and as recently as early September that were unusual, and not the decline since then, as the differential between Midwest and Gulf Coast prices is now more typical.

Previous analyses by EIA and others, including the Federal Trade Commission, have established the general causes of the sharp runups in Midwest gasoline prices prior to the 2000 and 2001 summer driving seasons. Low inventories, the introduction of Phase 2 reformulated gasoline (RFG), the use of an unusual ethanol-blended RFG in the Chicago-Milwaukee area, and refinery and pipeline problems have all been cited as contributing factors to high spring gasoline prices in the region. Additionally, in August of this year, a fire at a significant Chicago-area refinery (on top of the earlier closure of another refinery in the same area), along with rapidly-declining late-summer inventory levels, pushed prices sharply upward until Labor Day. Although the refinery remains largely out of service, the end of the summer driving season, a weakening economy, and the effects of the events of September 11 combined to relieve pressure on the gasoline supply-demand balance in the region.

Although not as pronounced as in the Midwest, a similar lessening of unusually tight market conditions appears to account for most of the remainder of the gasoline price declines in California and elsewhere in the nation not attributed to crude oil prices and seasonal factors. California, which has seen frequent gasoline price runups due to supply tightness in recent years, experienced prices as much as 50 cents per gallon higher than those on the Gulf Coast as recently as early July. However, West Coast gasoline prices, like those elsewhere, began declining early in the summer, and continued to fall through most of August, even after those in the Midwest and other regions had turned upward. Nationally, estimated gasoline demand fell below year-ago levels in August and September, while refinery production and imports remained relatively strong, pushing inventory levels to the upper end of their typical seasonal range.

Summary

The U.S. average retail price of regular gasoline has fallen nearly 48 cents per gallon from its peak in mid-May through October 29, 2001. With the exception of the Midwest, average prices have fallen about 39 cents per gallon during this period, of which about 21 cents is accounted for by declining crude oil prices, and up to 10 cents more by seasonal factors. The remaining 8 cents may reflect such other influences as a weaker economy and both supply and demand impacts of the terrorist attacks. The decline in the national average is inflated by a drop of more than 60 cents per gallon in the Midwest, reflecting a return to a more normal supply/demand balance in that region following very tight conditions in the spring, and a refinery fire in August. While even a short-term forecast of retail gasoline prices is highly uncertain, recent continuing declines in spot market prices, along with the typical lag relationship between spot and retail prices, suggest that further moderate retail price declines are possible in the coming weeks.

  

Contributing to this analysis was Michael Burdette, a consultant to the Energy Information Administration.

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