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Higher fuel prices in the US may soon crimp oil demand

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Garrett Golding

June 21, 2022

Benchmark West Texas Intermediate (WTI) crude oil prices rose, jumping from an average of $71 per barrel in December 2021 to $109 in May 2022. U.S. inventories of gasoline and diesel are dwindling and refining capacity is down, but export demand remains strong.

Gasoline and diesel prices in the US are at record levels on a nominal (non-inflation-adjusted) basis (Charts 1, 2)

Much of the market commentary is that oil prices remain far from record levels in real (inflation-adjusted) terms. WTI oil prices averaged $128 per barrel in July 2008, compared to $169 today in real terms.

However, consumers buy refined products, not crude oil. The monthly national average for regular-grade gasoline, which reached $4.46 per gallon in May, was down from a 2008 peak of $5.35 in real terms, and gasoline prices between 2011 and 2014 were stable at recent, early-summer levels. Although daily national average prices have recently exceeded $5 a gallon, prices may still rise if one believes that consumers have experienced and to some extent endured such prices before.

Chart 1: Gasoline remains below record prices in real terms

Downloadable Chart | Chart data

Chart 2: Diesel prices exceed record levels in nominal terms

Downloadable Chart | Chart data

Yet there are complications – inflationary pressures unrelated to fuel prices, declining real wages and the scale of this latest price shock. Additionally, the large price spread between refined products and crude oil, particularly diesel, has amplified the impact of this shock compared to previous episodes.

These factors raise questions about whether US energy consumption can withstand higher prices for much longer. Without adequate supply response from crude oil production or refining capacity in the near term, demand destruction may ultimately be the only variable to slow and reverse fuel price increases.

Fuel has a low price elasticity of demand

US consumers historically reduce fuel consumption slowly as prices rise. This is primarily because most consumers have to drive to work, school, grocery stores, and other places every day. Additionally, there are no scalable alternatives that can be replaced immediately. Using public transport is mainly an alternative for those in dense urban areas, and buying a more fuel-efficient or electric vehicle at the first sign of higher pump prices is not an option for most.

Because of this, energy demand is known as price inelastic, meaning that as the price of the product increases, the quantity demanded decreases at a slower rate in percentage terms. For a price-elastic good, the quantity demanded falls at the same rate or faster than the price increases.

With a supply-driven price shock such as the current one, fuel prices can reach a level where consumers reduce spending on other goods due to price elasticity, posing a risk to the broader economy.

Consumer memories are short

Although fuel prices have risen significantly on an inflation-adjusted basis, consumers are unlikely to cite what they paid for fuel 10 years ago as a benchmark for current household budgets. Vehicle purchases, work and travel options and travel plans are made keeping in mind the latest prices.

Consider someone who bought a vehicle in December 2020, when gasoline prices were just $2.20 per gallon. Consumers expect fuel prices to remain at or near that level during their ownership period.

The longest-selling vehicle in the US, the Ford F-150, has a combined fuel economy rating of 20 miles per gallon in its V-6 configuration. With Americans driving an average of 13,474 miles in 2021, an F-150 owner’s annual fuel bill would increase by $5 per gallon to $1,886, or about $157 per month, if miles were unchanged.

Put another way, for a US worker in the first quarter of earnings (the bottom 25 percent), 9 percent of earnings now go toward gasoline purchases, up from 4 percent a year ago.

A problematic price premium for diesel

Distillates—a refined product category that includes diesel, home heating oil and jet fuel—is in short supply globally and subject to rising prices. US diesel prices have jumped 53 percent since December, while gasoline is up 34 percent. The main culprits: cuts in US refining capacity after the COVID-19 slump in 2020 and a global scramble since February to replace sanctioned Russian diesel exports and crude oil (which yields more distillates than other types of crude oil).

The spread between on-road diesel and WTI prices has never been higher (Chart 3) at the current spread, diesel will average $7 per gallon nationally—above the $5.57 average in May 2022—if WTI rises to $169 per barrel, the inflation-adjusted peak in 2008.

Chart 3: Price differential between crude oil, diesel has never been higher

Downloadable Chart | Chart data

These price increases are felt most acutely by freight and agricultural end users, increasing the cost of bulk transportation, deliveries and food production. For a farmer planting and harvesting 1,000 acres of corn this year using conventional tillage, at an average of 5 gallons of diesel per acre, the fuel bill for that crop would be $27,500 today and $16,400 in 2021.

Fuel prices are not the only inflationary pressure

Additional fuel costs will not be a problem in line with revenue growth. However, wages have failed to keep pace with inflation since the second quarter of 2020. As a result, real earnings fell at a pace not seen since 1979-81 (Chart 4)

Chart 4: Real earnings fall amid high inflation

Downloadable Chart | Chart data

Although real earnings are higher than in previous episodes of high fuel prices, most household budgets, particularly those in the lowest income quartile, have little room to accommodate a 50 percent jump in fuel costs. The rapid decline in the personal savings rate over the past year can be seen as evidence of tight budgets.

US fuel consumption is bending, not breaking

Still, US fuel consumption has shown resilience. There is no sudden drop in today’s high prices. Gasoline demand has only come in below seasonal norms so far, while diesel consumption has eased after a strong start earlier in the year (Charts 5, 6)

Chart 5: Recent US Gasoline Consumption Trajectories Pre-COVID-19 Levels

Downloadable Chart | Chart data

Chart 6: US diesel consumption trending lower

Downloadable Chart | Chart data

Demand for travel (especially foreign travel) may be the reason US fuel consumption is sticky amid the easing of COVID-19 restrictions. This will only provide a temporary boost in August when the summer travel season winds down.

At the same time, the proliferation of work-from-home options gives many workers the ability to reduce their commute fuel consumption—which is roughly 30 percent gasoline consumption—relative to pre-COVID-19 levels.

The continuation of the trend of working from home will help reduce energy demand and increase price elasticity, although it is too early to fully assess the impact. Complicating matters are low-wage workers, who are less likely to have work-from-home options and are more challenged by higher fuel prices.

All told, fuel prices may be closer to consumer pain thresholds than inflation-adjusted prices suggest. And if prices rise, expect consumers to respond by reducing fuel consumption and overall costs.



About the author

Garrett Golding

Golding is a senior business economist in the Research Division at the Federal Reserve Bank of Dallas.

The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

Energy inflation

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