Gas prices have been on everyone’s mind lately as inflation has continued to crimp paychecks and family budgets on everything from transportation to grocery bills. The national average price for a gallon of gas touched in at $4.90 yesterday (06/27/2022, based on data from AAA[1]), slightly off the recent highs attained a little less than two weeks prior when prices briefly went over $5 a gallon. Today’s prices are still a far cry from the $3.10 per gallon a year ago and the near decade long run of relatively cheap fuel unleashed by the U.S. shale oil boom.

Pundits and politicians alike have been quick to pin the blame on everything from the Biden Administration to the Russian invasion of Ukraine and to greedy oil companies price gouging the American consumer. As with any of the hot political topics of the day, the reality is more complicated than the one-line talking points bandied about by politicians of both parties in an election year. Investors, consumers, and politicians alike could benefit from understanding the factors driving the higher prices and the potential scenarios that could play out in both the near and longer term.

There is a confluence of factors—a perfect storm if you will—driving the current high prices at the gas pump. Here are the primary elements we believe are making a significant impact:

1. Russian invasion of Ukraine and associated sanctions

Sanctions have reduced Russian oil production and are expected to take volumes out of the global supply chain for a long time to come. China and India have significantly stepped-up purchases of Russian crude to partially fill the void left by European buyers, but on an aggregate basis, Russia’s crude oil production is down significantly since the start of the conflict. Exports of crude and petroleum products are expected to decline in 2022, contributing to the global supply/demand mismatch.

2. Current and forecasted global crude oil demand growth

Global demand for oil coming out of the 2020 COVID-19 pandemic and associated lockdowns was higher than many expected. The so-called “transitory” inflation anticipated by the Fed appears to be more durable than originally thought, and the rapid recovery in global oil demand has certainly contributed. The latest forecasts from the International Energy Agency (IEA) show global demand outpacing pre-COVID-19 levels on a global basis in 2023, while U.S. Energy Information Administration (EIA) projections have 2023 total world oil consumption coming in just below 2019 levels.

3. Lower U.S. production relative to 2019 and early 2020 levels

U.S. oil production fell dramatically in 2020 following the COVID-19 lockdowns and the subsequent collapse in demand. This led to oil prices on the front-month WTI[1] futures contract briefly touching negative territory, settling for -$37.63 a barrel on April 20, 2020. The latest boom and bust cycle has only increased the already significant investor pressure on oil producers to maximize cash flow generation and return free-cash-flow to shareholders in the form of higher dividends and share buybacks. The large CapEx (capital expenditures) budgets and lofty production growth targets of the last two decades have been replaced by capital discipline, shareholder focused capital allocation decisions, and flat to modest production growth rate targets in the low to mid-single digit range.

Some have painted this as an attempt by U.S. oil companies to exploit consumers. The reality is that they are price takers in a global market and are still beholden to their investors (as is the case with any business), thus their capital spending and investment decisions are made in the context of attempting to provide the highest possible return for their shareholders for the level of risk taken to achieve them. If they could control prices, why would they have allowed the severe price drops of 2008, 2014 to 2016, and 2020 that have contributed to their meager investment returns over the last 10 to 15 years? When you look at the volatile price swings of crude oil over the last 20+ years and the comparatively low equity performance of the U.S. Energy sector as measured by the Energy Select Sector SPDR® ETF (XLE)[1] over the last 15+ years—even with the outsized returns of 2021 and year-to-date 2022—the push by shareholders for oil executives to exercise some capital discipline certainly seems warranted.

4. Supply chain backlogs & inflationary pressures

The same supply chain backlogs and inflationary pressures affecting other industries are impacting oil production. Shortages and rising costs of steel, frac-sand, oil-field services, and labor are putting pressure on CapEx budgets and making it harder for supply to catch up with demand.

5. Pressure to reduce emissions & transition to alternative energy sources

Stakeholders of all kinds, from investors to government officials, to private citizens in oil and gas producing communities, are actively pushing for energy companies to reduce greenhouse gas emissions and accelerate the transition to alternative energy sources such as wind and solar. This has shifted investments away from traditional energy production in recent years and towards alternative energy production sources.

6. Regulatory uncertainty amid the push for an alternative energy future

Going hand in hand with the prior point, the competing forces for investment dollars to finance alternative energy production and research while simultaneously striving to maintain affordable and reliable energy today have made it difficult for regulators, investors, and industry executives alike to strike the right balance. The lack of a clear and consistent regulatory framework, combined with the uncertain picture of future energy demand and production, have likely contributed to lower levels of investment—in recent years and for the near-term future—in oil and gas production and refining capacity that has in turn contributed to higher prices.

7. Limited oil refining capacity (and reduced capacity relative to 2020) combined with high-capacity utilization rates

Crude oil refining capacity has decreased, both in the U.S. and on a global basis since the start of 2020. U.S. refining capacity has gone down by roughly 1 million barrels per day (mbpd), as aging and unprofitable refineries across the country were shutdown or converted to biofuels refineries. Globally, refining capacity has dropped by roughly 3 mbpd over that time frame, and the run-rate refining capacity utilization in the U.S. is well over 90%, a level which industry insiders and analysts have said is likely unsustainable. This in turn is contributing to historically high crack spreads (an industry metric measuring the different between the cost of crude oil and the price of refined products produced from that oil, such as gasoline, jet fuel, and distillates including diesel) and higher prices at the pump for consumers.

The takeaway

The Biden Administration and Big Oil executives have traded barbs as to who is responsible for high fuel costs and have struggled to find common ground on the right steps to try to lower prices. Regardless of one’s views on energy policy, there is little that can be done to provide immediate relief for consumers at the gas pump. Many of the factors contributing to current high prices are beyond easy, quick fixes. Investments in oil and gas production and refining capacity are long-term in nature, generally requiring long lead times for permitting and regulatory approvals, sourcing of materials, and the construction/building out of infrastructure before operations can begin. Additionally, the securing of new financing has become more complicated given the backdrop of macro and industry trends that currently favor alternative energy sources that look to reduce greenhouse gas emissions. As is often the case with these types of challenges, the details are more complex than the easy headline.