What Will Cause Gas Prices to Fall?

I’m sure you don’t need me to tell you that gas prices are high. Even if you don’t have firsthand experience of that as a consumer, it is one subject being covered ad nauseam by news outlets with both a left and right wing bent. The former will hint at it being the fault of big bad oil companies who are ripping off consumers, the latter will say just as earnestly that it is Joe Biden’s fault and that if we would just stop attacking those poor defenseless oil companies, we would all be okay.

That is pretty typical of what happens when an economic or market question gets politicized. The desire to hurt the other side leads to two opposing narratives, both of which contain elements of the truth, but which combine to obscure the actual problem and thus make a resolution less, not more, likely.

The truth here is that yes, oil companies have made massive profits as oil prices have soared and the situation has been made worse by a White House that has discouraged investment in the industry. However, if you were to somehow reduce margins forcibly at big oil companies and/or introduce a more drill-friendly environment for crude in the U.S. tomorrow, the impact on prices at the pump would be minimal. Neither of those things are the cause of gas being above $5 a gallon.

Profits at oil companies may be high, but there is no evidence that those companies are really squeezing every last cent from the consumer. Exxon Mobil (XOM), for example, reported a profit margin of 6.25% for the quarter ending March 2022, down from 10.91% at the end of last year. That, as you can see from the chart below, is easily in line with the norms over the last five years:

Figure 1: XOM Quarterly Profit Margin

The dollar amount of those profits is higher, but that is a function of higher crude prices, prices that are set by a driven by basic supply and demand, not by Exxon or any other company.

Is Fox News right, that it must be Joe Biden’s fault? Well, not really. For one thing, capital expenditure among oil and gas companies peaked in 2014 and has been at low levels ever since. That is because those companies themselves are looking forward to a future where oil plays much less of a role in meeting the world’s energy needs and are loathe to “drill, baby, drill” even if allowed or encouraged to do so. Add in OPEC+ supply constraints for years after the covid shock, a war in Ukraine that has led to a large part of the developed world refusing to use Russian oil, and demand that has been climbing as growth is beginning to return ... really, the surprise is that gas is “only” around $5/gallon.

The thing is, Joe Biden doesn’t make OPEC’s decisions, nor does he make Putin’s foreign policy, nor does he control global demand for oil. These things are, quite simply, largely beyond his control, and arguing otherwise is disingenuous.

So, if high gas prices are neither Biden’s fault nor the result of margin squeezing by oil companies, what can be done? Where can consumers look for some relief? Joe Biden will today call for a federal gas tax holiday, which is a something of a start; however, the proposal will probably not make it through Congress and, even if it does, it will reduce prices by only around fifteen to twenty cents. And that is assuming that the difference isn’t gobbled up by refiners, distributors, and retailers. It is a gesture, not a solution.

There are actually two things that will bring relief at the pump. The first is Adam Smith’s "invisible hand." Commodity markets are a relatively pure expression of the supply and demand pricing theory, a theory which states that as prices rise, producers will be incentivized to increase output in any way they can. Crude has held above $90 a barrel for four months now, and oil companies who refuse to take advantage of that are risking accusations of dereliction of their duty to their shareholders. That is already beginning to show, with rig counts gradually increasing. Given the time lag involved in drilling, that can be expected to continue for a while, even if prices start to drop, and that will increase global supply.

On the demand side, help will come from a seemingly unlikely source, and it will have a price. The Fed is raising interest rates and reducing market liquidity with a clear and stated goal of slowing down the U.S. economy. Nor are they alone, as rate hikes by both the Bank of England and the Swiss National Bank last week showed. Central banks are determined to slow growth to control inflation, and when they set out to do that, they usually succeed. It may or may not lead to an actual recession but putting the brakes on growth around the world will reduce demand for oil, no matter what, and that will bring the price down.

In fact, crude futures (CL) indicate that those two things, increasing supply and reduced demand expectations, are already having an impact, with the front-end contract challenging support created by an upward trend line at around $104 this morning.

So, if you want lower gas prices, don’t look to politicians or try tame the greed of oil companies. Instead, look to the Fed, and simply wait for the oil companies to give in to their greedy impulses to increase output. Both will have some negative consequences for the economy, but combined, they will push prices at the pump lower.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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