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[ Gas Prices: How Low Can They Go? ]

Hoping for lower prices at the pump? Don’t hold your breath. Here’s why.

During presidential election years, pretty much anything can become a political football. And so it‘s not surprising that with gasoline prices well above $3 a gallon, the cost of gasoline has become a topic on the stump. Mitt Romney and his fellow Republicans—as well as much of the public—blame the president for the rise in prices. (See here, here, here and here. One former Republican hopeful even promised, if elected, to bring the cost down to $2.50 per gallon.) President Obama has pointed the finger at speculators and oil companies (see here).

But all the political posturing aside, an argument can be made that the high prices we are paying are actually a reflection of the economics at play. It also suggests that the prospects for cheap oil are pretty thin–and will be even after the election.

Why? For one, oil companies are not charities; they operate on profits. And because oil production costs help inform the baseline price of gasoline, a growing dependence on unconventional oil means costs are on the rise.

Crude Oil and Gasoline: History As a Guide

The graphic below is an 18-year look at U.S. prices for crude oil and gasoline.

Gas and Oil Prices, 1994-2011

Oil price (left axis, red line) is the weekly West Texas Intermediate (WTI) spot price per barrel, the main benchmark for North American crude. The gasoline price (right axis, blue bars) is the U.S. weekly average per-gallon retail price for all grades. (Data sources: Weekly Cushing, Oklahoma WTI Spot Price and Weekly U.S. All Grades All Formulations Retail Gasoline Prices)

Currently, prices are running about $91 per barrel of WTI crude, $111 per barrel of Brent crude (another stream used as a marker for oil prices), and gasoline is about $3.80 per gallon.

Since the end of 2010, gasoline has not been below $3 a gallon at the same time crude has not been below $80 a barrel. Taking a longer view, minus the recession’s exceptional economics (November ’08–May ’09), crude has stayed above $60 a barrel and gas prices above $2 a gallon since 2004. (Interesting to note how quickly we adapt to economic realities. Not all that long ago, $2 a gallon seemed an exorbitant price to pay. Now I’d guess most folks would welcome anything under $3 at the pump.)

All the political maneuvering notwithstanding, the price of a gallon of gasoline tracks pretty closely to the price of a barrel of oil. For the sake of argument, let’s use this historical record as the baseline for the range of gas prices we can expect for any given price of crude. Over this interval $60 barrels of crude have translated to about $2.30–$2.50 per gallon of gas, $80 barrels to about $2.80–$3.40 a gallon, and $100 barrels to $3.40–$3.80 a gallon.

Crude Oil Costs

With this albeit crude (no pun intended) scale of gas and oil prices in hand, let’s look at what it costs to produce oil.

Some countries, like Saudi Arabia, still have conventional supplies of oil that are so accessible that the fuel almost pumps itself out of the ground. OK, not really, but the fact is that that easy-access conventional oil is produced relatively cheaply. As long as there is an abundance of this type of oil, crude oil prices, at least in principle, should be low.

The price of a barrel of Saudi crude was estimated at $45 a barrel in September 2011, and that is probably a pretty good indicator of what it costs the Saudis to produce a barrel of crude. However, the current price for a barrel of crude from Saudi Arabia is in the $90-100 range. Why? Unrest and instability in the region are factors. And because global markets require more expensive unconventional oil (see below) to meet demand, the Saudis are able to get that price. And that’s a good thing for the Saudi Arabian government, which uses oil sales revenues to run the government and meet the country’s current financial commitments.

As Saudi Arabia (working in certain margins of profit) pretty much sets world prices, it’s a safe bet that oil will remain in the $80-$100 per barrel range and our gasoline prices will hover in the $3-$4 per gallon range.

What About Domestic Supplies?

The United States has a bunch of oil. (See here and here.) So why wouldn’t drilling more domestic crude drive the price down? Here’s one reason: The United States has very little easily accessible conventional oil left, so tapping our oil is getting more and more expensive. We are having to drill offshore in deeper and deeper water, in harsh Arctic environs, and in tight formations that don’t give the fuel up readily. All this means it costs companies more to make a barrel of oil today than it did in the past. As long as crude oil prices are high, oil companies will exploit those unconventional plays—as they currently are. But if the price falls, those companies will likely stop drilling at some point until another price rise.

That price—the breakeven price—varies across the industry and the type of oil. For North Dakota’s Bakken oil (a tight oil formation), it’s thought to be less—about $50-$60 a barrel for the most efficient scalable companies. For deepwater offshore oil, the price is in the $70-$80 a barrel range. But breaking even, of course, is not what these companies are about—they want to turn a profit and that ensures the price will be higher.

A government analysis of production from in and around Prudhoe Bay provides a case in point.

If oil prices drop too much, the Energy Information Administration (EIA) found, North Slope oil will become too expensive to produce and the taps will be turned off—until some later date when the economics make sense again. What price would bring this about? According to EIA projections, a price of about $60 a barrel in 2015 would, by 2026, lead to a shutdown of North Slope production even if that price rose to $64-$77 a barrel in 2025. Such crude prices would simply make this expensive-to-produce oil too expensive to drill. Losing North Slope production would mean a loss of at least 350,000 barrels per day. Bottom line: to keep North Slope oil flowing, we will need to pay in $2.50-a-gallon range or above.

What About Canadian Tar Sands?

Remember the Keystone XL Pipeline, which would bring tar sands oil to the United States? Could that lower prices? Not likely. The breakeven point for tar sand oil that is mined would start at about $80 a barrel, but then once the oil is upgraded (diluted so it can flow like oil), the breakeven price becomes $100 a barrel. For in situ operations the breakeven price may be as low as $60.

And here’s an interesting example of how lower priced oil can undercut the development of more expensive oil. Remember that Bakken oil that only requires $50–60 per barrel? The availability of that oil is being credited with delaying development of tar sands projects.

The Bottom Line

With our growing dependence on unconventional oil, some economists set the current floor on crude oil at about $80–$100 per barrel—if the price falls below this range, unconventional oil will become less attractive and production will drop off until the price reverses and those plays become profitable again. This suggests that regardless of who is in the White House, we can expect to continue filling our tanks for between $3 and $4 per gallon.

The Energy Information Administration, which is in the business of making energy predictions, suggests that the current nostalgia for $2 gallons of gasoline will be tomorrow’s nostalgia for $3 gallons. The EIA’s so-called reference (best estimate) case puts crude at about $120–$130 per barrel in 2015. Not welcome news: When oil hit those prices back in 2008, gas was more than $4 a gallon at the pump.

With that bit of background now tapped, let’s see what the candidates say about gasoline prices in Wednesday night’s debate on domestic policy.

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