When average gas prices dropped below the $4.00 per gallon mark, as they finally did in the second week of August in some states, many drivers breathed a sigh of relief.
Household budgets have been feeling the pressure from sky-high fuel costs, and any downward trend is a welcome sight for financially strapped Americans.
But even if prices are trending in the right direction, we still have a ways to go.
According to AAA (opens in new tab), the average current price of $3.95 per gallon of regular unleaded (as of August 15, 2022) is still a painful increase from the $3.18 per gallon we were paying in August of 2021.
To understand if gas prices will continue to trend downward, we spoke to Ben Cook, the portfolio manager of the Energy Transition Fund at Hennessy Funds.
Here’s what you need to know about the future of gas prices.
What goes into gas prices?
Seeing an outrageous price at the pump can prompt grumbling about greedy oil executives.
But rather than someone named Huntington Von Oil Baron III lighting cigars with $100 bills while gleefully pushing a “prices go up” lever, retail gas prices actually reflect four main components:
- Cost of the crude oil
- Costs (including profit) of refining the oil
- Costs (including profit) of distributing and marketing the fuel
- Federal and state taxes
According to the U.S. Energy Information Administration (opens in new tab), as of 2021, the average retail price of a gallon of gasoline broke down into these percentages of the four main price factors:
- 53.6% crude oil costs
- 14.4% refining costs
- 15.6% distribution and marketing costs
- 16.4% taxes
Considering taxes make up the second largest component of the price at the pump, it's understandable why several states have enacted or proposed gas tax holidays or other tax-related relief at the pump.
But understanding the components that make up the cost of a gallon of gas cost doesn't explain why the amount you pay can shift so dramatically — so it's easy to assume the industry is greedy.
"The public perception of the refining industry is undoubtedly influenced by prices at the pump and political rhetoric only exacerbates these misperceptions," Cook explains. "But claims that the industry is responsible for 'setting pricing' are unfounded and importantly fail to address the true nature of supply and demand."
Basically, when gas prices reach historic highs or lows, changes in supply and demand are often responsible.
Why did gas prices spike in 2022?
Cook points out that supply and demand issues are precisely why the pump price was so painful in 2022–and those issues weren't confined to the United States.
"The market for gasoline is 'global,'" he explains, "meaning factors affecting supply and demand for gasoline around the world can impact the price of gasoline here in the United States."
So what has been throwing off our supply and demand? Though the global market is incredibly complex and can be affected by several events and issues, two major factors from the past few years have affected the oil market: The Covid-19 pandemic and the Russian invasion of Ukraine.
"The loss (for various reasons) of refining capacity globally, before and during the pandemic, left the industry under-equipped to produce the volume necessary to meet demand as the global economy emerged from the pandemic," Cook says.
With everyone resuming their daily commutes and planned road trips after two years of driving less, it's understandable that the lowered refining capacity would struggle to meet our return to normal driving behavior.
According to Cook, this increased demand also coincided with Russia’s February invasion of Ukraine, which made matters worse.
“Sanction-related supply embargos of refined Russian products (like gasoline and diesel) exacerbated supply shortages, forcing prices much higher both here and abroad,” he says.
Why are gas prices coming back down now?
Seeing higher prices at the pump may have been the first time the average driver understood that something was off about the gasoline supply. Still, the oil industry has been aware of the issue for much longer and has been working to increase supply.
“Refiners have ramped production to refinery capacity limits to produce gasoline which has improved the gasoline supply picture,” Cook says.
This ramped-up production is one part of the equation that has helped to lower costs below the $4 per gallon range.
However, the other side of the supply-and-demand equation has also affected the cost. You may remember from your introductory Economics class how price can affect demand: if prices go up, demand will generally go down.
When gas prices hovered near or above $5 per gallon, it had an effect on consumer demand, since most drivers tried to reduce their gas consumption to save their budgets.
As Cook explains it, “demand losses associated with reduced consumer travel have also contributed to the improved supply/demand balance.”
Will gas prices continue to fall?
Since supply is ramping up and demand fell because of pricing, we should expect prices to keep falling, right? Well, not so fast.
Cook explains that some of the diminished refining capacity isn’t going away, even with the currently ramped-up production.
“The loss of U.S. refining capacity has been affected by poor profitability and conversion of some existing plants to produce renewable fuels,” he explains. That lost capacity can’t be recreated overnight.
There is some potential good news on the way, if you look far enough down the road. “Some new capacity will come in the U.S., Middle East, and Asia by 2024,” Cook says.
But until that new capacity is available, “the loss of capacity over the last several years won’t be fully offset until the middle of the decade–2024 or 2025.”
As for the demand side of the equation, Cook believes that it will remain high, barring an economic recession.