Most of us put the blame for increases in gasoline prices on the greed of oil companies and refiners. There is more to this story, though.

Oil Depletion Over the last five years oil prices have increased from about $20 per barrel to a high of $78 in 2006 and have now settled to $60-65 range. Much of the gasoline price increase can be explained by this rise in oil prices. But the refining margins have doubled over the last year; refiners as well as oil companies are profiting from tightness in the gasoline markets.

The world oil production during the last two years has been flat at 84.5 million barrels a day, which means that every 12 days the world consumes a billion barrels of oil. Since oil is discovered at the rate of about 8 billion barrels a year and the discoveries are decreasing, the world uses 3 barrels for each one that is found.

The increase in oil prices is fundamentally caused by scarcity of good drilling prospects. About 45% of the world’s oil comes from the 120 best producing fields. Most of them are huge, but over 40 years old. Over the last ten years the oil production in UK, Norway, and Mexico has peaked and is now in steep decline. These are just the latest of the 33 countries that are past peak production, with many of the rest of the 48 major oil producers approaching the top.

Saudi Arabia’s production has decreased by over 1 million barrels a day over the last year. Its largest oil field, discovered in 1948, is in decline. This field is the largest in the world and has provided over half of Saudi Arabia’s production over the last half century. Kuwait’s largest field is also in decline.

In addition to depletion of the world’s largest fields, resource nationalism limits the supply of new oil. This is clear from the actions of Russia’s president Vladimir Putin, whose government has renegotiated contracts with western oil companies on projects under development. President Hugo Chavez is nationalizing Venezuela’s oil industry. News from Africa inform us that various insurgent groups are also vying for a share of the oil profits.

The world population is increasing by 77 million a year. Demand for oil is growing, spurred by the industrialization of China and India and in oil producing countries where populations are young and gasoline subsidized.

A group of petroleum geologists founded the Association for the Study of Peak Oil (ASPO) seven years ago to inform the public, the public officials, and business leaders about the true state of the world’s oil resources. ASPO has concluded that world’s original endowmentto about 2.5 trillion barrels of recoverable oil of which 1.1 trillion has been used. Since oil production follows roughly a bell-shaped curve, the peak production will take place when about half of the oil has been extracted. Calculations estimate this will take place within three years. The July 2006 peak production of 85.5 million barrels a day could be the peak for all time.

Gasoline Gasoline prices at the retail level reflect the price refineries pay for oil. The high prices today are partly a reflection of scarcity. The size of the refined product inventories are controlled by setting prices to levels that assure profits and prevent shortages. Accidental fires occur in refineries often and, if they should lead to a perceived shortage, the prices are sure to go up. Gasoline retailers do not want to put up a sign saying they have run out, for this is a sure way to lose some customers.

Weather also contributes to glitches in the supply. Refineries convert in spring to produce more gasoline, and revert to ramp up heating oil during the fall. Should demand for heating oil remain strong during a cold winter, then the summer gasoline production will be delayed. Added to this is the need to refine various blends of gasoline, as reformulated gasoline has been mandated by various states. All this requires that refineries be shut down for conversion and maintenance once or so a year.

No new refineries have been built in the US during the last 30 years and some have been shut. Refiners complain that environmental regulations and low profits have hampered their plans. However, they have managed to add capacity by expanding the existing facilities. Furthermore, they may be unlikely to increase refining capacity to handle a declining supply of oil.

The oil companies are profiting handsomely. The higher prices today give refiners a windfall. When questioned, they are ready to point out that they do not set the oil prices, which are determined by the oil futures markets. This is a way to sidestep the issue, for they know very well that the discovered oil in the ground generated the windfall they now enjoy. These profits are paid by the retail customers in the end.

Responses The ultimate cause of high gas prices is the finiteness of oil in the ground. The best policy proposals for the future need to keep this in mind. The policies put in place over the last six years have not been encouraging.

At the federal level, a war with Iraq to control the best fields in the Persian Gulf has incurred a heavy toll in lives, injuries, and money. At the state level, corn producing states have embraced corn-based ethanol as a salvation.

Ethanol from corn is a marginal fuel. Its production is being felt through higher food prices. Since most of the corn in the US goes for animal feed, meat and milk prices have increased. Fuel shortages will be postponed by a couple of years, but in doing so high food prices will come in their wake.

In the meantime, absent is the public discussion and support for the Ohio Hub Plan to connect Cincinnati, Dayton, Columbus and Cleveland by passenger trains. Rail transit is the most sensible plan, for as oil begins to deplete, rail becomes the best option for traveling between these cities. Good public transportation within these cities will need to be developed in the interim.