Low-Energy Fridays: How will conflict in the Middle East affect gas prices?
How high will gasoline prices go, how long will they stay high, and how bad will it be for the U.S. economy? Many Americans are asking these questions in light of the current military operations in Iran. Given the proliferation of uninformed takes, a more nuanced explanation of what to expect and what could change in the coming days and months is in order.
Last week’s Low-Energy Fridays explained that while conflict and the resulting high energy prices are bad news for the economy, they cannot be the sole factor on which to base national security policy. At the same time, policymakers must fully understand the costs of their national security strategy—which brings us to today’s questions:
How high will gasoline prices go?
This is the million-dollar question, and I would be skeptical of anyone who gives a definitive answer. One common connection is that gasoline prices averaged around $5 per gallon the last time oil prices were this high (over $100 per barrel in 2022). But while this may be true, it’s important to understand why gasoline was so expensive back then.
As I wrote during that period, while the Ukraine-Russia war put upward pressure on gasoline prices, the scarcity of refining capacity in the United States explained most of the increase. Because U.S. refining capacity is now higher than in 2022, it should theoretically have less bearing on pump prices—although that impact also depends on gasoline consumption, which is also higher.
The cost of oil itself is responsible for about 60 percent of the cost of gasoline. Oil prices were around $60 per barrel in January; however, if prices surge to $120 per barrel, then the cost of oil consumption will double. U.S. consumers spend about $1 trillion per year on petroleum energy expenditures ($2.7 billion per day), so a doubling of oil prices would reflect a commensurate expenditure increase from petroleum products. Average prices at the pump were $3.15 per gallon prior to the conflict in Iran, approximately $1.89 of which reflected the oil cost. If oil prices were to double, then gasoline would cost $5.04 per gallon on average. But this is far from certain, as oil prices are highly sensitive to changes in consumption and production as well as recently announced releases from the Strategic Petroleum Reserve.
How long will gasoline prices stay high?
On Sunday, March 8, Energy Secretary Chris Wright noted that one explanation for elevated oil prices is the risk oil sellers are feeling amidst the conflict. Because about 20 percent of the world’s oil supply ships through the Strait of Hormuz, a 20 percent loss in market supply is potentially being baked into prices. This explains the bonkers oil price fluctuations as of late; however, medium- and long-term price impacts depend upon how much supply can reach the market relative to consumption.
It’s also important to consider how seriously the war is impacting upstream oil production. While the capacity to produce oil remains high, producers are voluntarily reducing their output because they have fewer places to sell or store oil. If and when it’s safer to transit the Strait of Hormuz, global oil supplies and prices will probably start to return to normal—but that’s a big “if” in and of itself. Oil tankers are easy targets for drones, and naval mines are cheap and easy to deploy. And because the United States is not powerless against these forms of warfare, the tactical situation in and around the strait will likely impact oil prices significantly in the medium term.
There is also the question of Iran’s own oil production. Israel has started targeting Iranian oil facilities. Reportedly, only storage sites have been destroyed; however, if refineries or production sites are destroyed then global oil production will be similarly reduced. It’s also possible that the United States and Israel might seek to prevent Iranian oil from being sold on the market, as oil sales would be a source of funds that could sustain a war effort. (Under peaceful conditions, Iran produces nearly 4 million barrels per day of petroleum products and represents roughly 4 percent of the world’s total oil supply.)
While Iran’s oil production may seem too small a share of global supply to seriously impact oil markets, that’s not a correct assumption. Global oil markets operate on extraordinarily tight margins, to the point that even relatively small changes in supply or demand can cause big price swings. For example, oil prices fell approximately 70 percent during the U.S. shale energy boom in 2015 even though global production had only increased by about 3 percent from the previous year.
It’s unclear whether alternative oil producers can increase their output to satisfy consumer demand. The United States’ ability to be a “swing producer” is a major factor here. The nation’s “proved reserves”— oil sources that are economical to extract at the current price—hit record highs in 2022. When prices go up, oil reserves that were previously too expensive to extract from become profitable, and reserves then increase. Reserves remained high even in 2023, so it’s natural to presume that U.S. oil producers’ capacity to satisfy the market shortfall is as good as it has ever been.
On the flip side, to increase output and reduce prices, oil producers must invest more in infrastructure and expand operations (including for export). As noted in my recent Low-Energy Fridays on Venezuela, such investments are contingent upon confidence of a continued business environment conducive to operation. More simply, if the oil industry fears that a future administration may force them to shutter operations via the same laws that the Trump administration used against the renewables industry (and that the Biden administration used against the oil and gas industry), then the investment appetite among domestic oil producers will be seriously blunted.
How bad will this be for the U.S. economy?
This is also a tricky question. The economy is not one amorphous unit—it’s an amalgamation of many productive activities. Higher oil prices will increase costs throughout the economy because nearly everyone relies on petroleum products in some way. This decidedly negative event is sometimes referred to as an “oil shock.”
A study from 1983 found that an increase in oil prices preceded nearly every economic downturn in the United States, making a solid connection between energy costs and overall economic activity. This makes sense, as the energy crises of the 1970s coincided with weak productivity growth; however, recent literature notes that the dynamic has become more complex. There is one industry that benefits from high oil prices, and that’s the industry selling the oil. U.S. oil production is much larger since the growth of shale production, and we are now the largest oil producer in the world.
Therefore, the economic question is whether the benefits to the oil industry are felt elsewhere. The answer to this seems to be yes, as a Kansas City Federal Reserve study from 2018 found that high oil prices result in increased investment, even in non-energy sectors of the economy.
The same cannot be said for the many nations we trade with that do not have large domestic oil industries. The cost of imports, particularly for petroleum intensive commodities, is likely to rise. We may also experience less investment with other countries that suffer more acutely from oil shocks—most notably Europe, our largest source of foreign direct investment at $3.6 trillion.
Overall, the economic news will be a mixed bag. Most Americans can expect negative effects as the costs of energy and goods rise in the near term, but increased earnings in the oil industry may offset the long-term economic effects. More plainly, oil-rich regions of the country will do well economically in the near term while oil-poor ones do worse, and the nation’s economic health over the medium term will hinge upon whether economic gains in the oil industry offset investment losses elsewhere.
Conclusion
Just how seriously the volatility of oil markets impacts Americans is largely contingent upon two things: the tactical situation in Iran that determines the flow of oil through the Strait of Hormuz and how conducive the U.S. business environment is to increasing oil production to cover shortfalls. The economic impacts will be uneven regardless, as oil-rich regions will benefit from higher prices. But the increased economic output in those areas may result in future investments in non-energy industries.