Pain at the Pump: It's Time to Start Thinking About $7 a Gallon Gasoline

By Jason Simpkins
Associate Editor

U.S. consumers barely had time to get used to the idea of $4 a gallon gasoline before prognosticators started talking about $5 a gallon fuel.

And unfortunately for the U.S. economy, the worst is yet to come.

The average price of gasoline in the United States broke $4 a gallon for the first time Sunday, following a double-digit surge in oil prices last week. And despite an economy that appears to be in an increasingly fragile state, experts are already debating the potential for gasoline to hit $5 this summer.

But here's what most economists aren't saying yet: U.S. motorists could easily be looking at $7 a gallon gasoline within two years. And that could have a disastrous impact on the U.S. economy.

"The bottom line is that the effect on the economy is going to be a lot worse than anyone's talking about right now," said Money Morning Investment Director Keith Fitz-Gerald, a longtime energy bull who recently boosted his oil-price projection to $225 a barrel. "The bottom line is this: Until someone develops a truly [interchangeable] alternative for oil and gasoline - something that works the same, costs the same and is just as effective - Americans are just going to have to face the fact that over time they're going to pay more."

First Stop: $4

According to a new survey by the national automotive group AAA, unleaded regular gasoline reached a national average of $4.005 a gallon on Sunday, up from $3.67 a month ago and $3.10 a year ago.

The Lundberg Survey, a systematic review of prices at 7,000 gas stations nationwide, last week indicated that the retail price of a gallon of gasoline had reached $3.9985, an increase of 20.5 cents a gallon since the middle part of May.

Gas prices are up 89 cents a gallon from a year ago.

The main culprit for the price increase has been the meteoric rise in oil prices, which have soared 110% in the past year. According to the U.S. Energy Department, the cost of crude accounts for 73% of the price of gasoline. For this reason, many experts anticipate that the price of gasoline will continue to rise in near lockstep with the price of oil.

"We can expect some further increases at the pump," Trilby Lundberg, editor of the Lundberg Survey, told Reuters. "If crude oil prices stay at nearly $139 a barrel, a 30-cent rise [for a gallon of gas] over the next few weeks is possible."

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Gas prices are already nearing $4.50 a gallon in many parts of California. Motorists in San Francisco are currently paying an average of $4.42 a gallon. In Oakland they're paying $4.39 and in San Jose $4.40, the San Francisco Chroniclereported yesterday (Monday).

Over the weekend, several cable TV news broadcasts even showed sections of California where gasoline prices were approaching $5 a gallon. In Southern California, some motorists are actually driving down to Tijuana, where gasoline is $2.75 a gallon - compared to the $4 a gallon or more they pay near home.

For truckers who use diesel fuel, the difference is even more dramatic: In California, diesel is averaging $4.71 a gallon. In Mexico: It's $2.10.

Why the disparity? In Mexico, gasoline stations operated by the state-run Petróleos Mexicanos - better-known as Pemex - everywhere are selling regular gasoline for more than $1 a gallon less than in the United States.

So far, analysts are divided on whether the average U.S. gasoline price will hit the $5 mark this year. There's a case to be made either way.

The Case for $5 Gas

Analysts estimate that for every $1 increase in the price of oil, gasoline prices rise 2.5 cents. And while crude futures retreated from their record high levels yesterday, the long-term outlook is for higher gas-and-oil prices.

Since 2005, global oil production has remained stagnant, but demand has increased exponentially. Even if American consumers are unwilling to pay $4 a gallon for gasoline, and U.S. demand plummets, global demand will continue to escalate.

Eduardo Lopez, an analyst with the International Energy Agency, told The Independent that America's role as the global arbiter of oil prices - the United States consumes one out of every four barrels of oil used worldwide - is ebbing.

"Demand is coming from emerging markets. As long as the [United States] doesn't collapse, it doesn't really matter if the mature economies are slowing," Lopez said.

While the International Energy Agency expects demand in industrialized countries to decline by 0.7% (about 300,000 barrels of oil per day) this year, the Paris-based group says oil consumption in the rest of the world will grow by 3.7% (1.4 million barrels a day).

China's net oil imports totaled 44.95 million metric tons in the first quarter, up 15%, and net imports of oil products rose by 32% from a year ago, according to the Asian nation's General Administration of Customs.

Meanwhile, India is expected to overtake the United States, Japan and China as the world's leading net importer of oil by 2025. Since 1997-98, alone, India's petroleum imports have almost tripled.

In 1970-71, India was importing 11.66 million metric tons of crude oil. By 2005-06, however, the imports had increased to 99.40 million metric tons, the Economic Times reported.

Together, China and India will account for 45% of the increase in global primary energy demand through 2030. The two countries' net oil imports are expected to jump from 5.4 million barrels a day in 2006 to 20 million barrels a day in 2030, which could create a "supply crunch" as early as 2015 according to the IEA.

Many other developing nations throughout the Middle East and Latin America are also consuming more oil.

"This a world oil market," Severin Borenstein, a business and public policy professor at the University of California-Berkeley, told the San Jose Mercury News. "A lot of smaller countries want oil more oil, so it's hard to point to [China and India] as the boogeyman."

Like Money Morning's Fitz-Gerald, Borenstein expects gas to cost between $6 and $7 a gallon by summer 2010.

The Case Against $5 Gas

Other analysts point to declining demand throughout the United States, arguing that cash-strapped consumers will opt to leave their car in park.

"Five dollars? I don't see it happening," Denton Cinquegrana, who tracks West Coast gasoline markets for the Oil Price Information Service, told the San Francisco Chronicle.  "Demand is just so [lousy] right now."

For the Memorial Day holiday week - the official start of the summer driving season -- U.S. gasoline demand fell 4.7% from a year earlier, according to the Energy Department. And in the past four weeks, the country has used 1.6% less gasoline than a year ago, the Energy Information Administration reported.

A survey of 43,000 people nationwide was recently conducted by the market researcher, The NPD Group, which found that high gasoline prices had induced 12% of respondents to cancel planned vacations. And about the same amount have tried carpooling as a means of coping with those higher fuel costs.

Also, 6% of those surveyed tried telecommuting, 5% started working closer to home, and 8% started using public transportation.

Another 6% of respondents already had purchased vehicles that were more fuel-efficient.

Indeed, year-over-year sales of hybrid cars surged 25% during the first four months of 2008. And the trend only grew stronger in May, when sales jumped 58% - outpacing a gain of 18% in April, the Los Angeles Times reported.

Meanwhile sales of pickups dropped 16.8% in the first four months of the year, Autodata Corp. reported. Sales of SUVs dropped 9.9% and luxury vehicle sales fell 12.9%. Sales of small cars, on the other hand, rose 7.5%

Additionally, U.S. gasoline supplies may increase over the next month as profit margins for refiners increase. For several months, the price of gasoline lagged behind the price of oil, so refiners were paying more for oil. But those higher costs were not yet being passed on to the consumer. As a result, turning oil into gas became far less profitable, forcing refiners to cut back on capacity.

Last month, U.S. refineries cut their utilization back to 85%  - down from 89% a year ago. And that's during a part of the year when utilization is typically 95%. Why the drop? Refineries wanted to draw down gasoline inventories to drive up the price of gasoline.

Gasoline supplies are expected to increase over the next month as refiners boost production to take advantage of the fatter profit margins they're earning. The margin for turning one barrel of oil into one barrel of gasoline has increased 22% since May 1 to $10.467 a barrel, according to Bloomberg.

Consequences for the U.S. Economy

While there may be room for debate about whether gas will hit $5 a gallon, there is a relatively strong consensus that higher gas prices are threatening the U.S. economy.

The Reuters/University of Michigan consumer confidence index fell again in May, down to 59.8 from April's reading of 62.6. The index is at its lowest level since June 1980.

"Consumers are painfully aware that their living standards are shrinking under the weight of higher food and fuel prices and see little hope for improvement anytime soon," Richard Curtin, the director of the Reuters/University of Michigan survey, said in a May 30 statement.

Unemployment added to those concerns after the Labor Department late last week reported that the economy lost 49,000 jobs in May, taking the unemployment rate up to 5.5%.

"The fact that confidence has gone down as inflation expectations are going up indicates gasoline has been an important driver because it's one of the reasons expectations are rising," Nigel Gault, chief U.S. economist at Global Insight Inc., told Bloomberg News.

Gault estimates that every 20-cent increase in the cost of gasoline shaves 0.3% off consumer spending growth.

This is all bad news for an economy that was already flirting with recession. If food and energy prices don't subside and consumer spending continues on its downward trajectory, analysts may not be just be talking about inflation anymore, but rather stagflation [For an in-depth look at stagflation in today's issue of Money Morning, please click here].

"What we're seeing here is a lot of additional pressure on a consumer sector that was soft to begin with," Joseph Careson, an economist with AllianceBernstein Holding LP (AB), told The Wall Street Journal. "Is it a tipping point by itself? It's close."

The "Worst" Case

By fixating on near-term prices, and near-term fallout, Money Morning's Fitz-Gerald says that investors and economists alike are missing the bigger point: Long-term - or at least until a true replacement for oil is found - the U.S. economy is going to be badly stung, and U.S. consumers who don't take steps to protect themselves are looking at a markedly reduced standard of living.

<p"Most of these forecasts are being made by economists who have never been professional traders," Fitz-Gerald says tongue in cheek. "Show me an economist who's ever correctly forecast anything more complex than an interest-rate increase, and I'll show you a gypsy fortune-teller who can go to Vegas right now and make all of us a lot of money consistently."

Absent some sort of a market "shock" - such as a short-term panic caused by a terrorist attack or some sort of a major catastrophe - oil prices won't rise in a straight line to $5, $6 and $7 a gallon, he says. There will be rallies, and retrenchments, as is the case with the price of any commodity.

But prices will rise, as there still is not a truly "fungible" - interchangeable - replacement for petroleum. That's what's needed, Fitz-Gerald says.

In the interim, investors should be "long" on oil and other commodities, should have alternative-energy-related investments, and should look for profit plays in ancillary sectors, Fitz-Gerald says.

"Investors need to plan accordingly," he said.

[Money Morning Executive Editor William Patalon III contributed to this report.]

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