Why Cheaper Gas Could Be Right Around the Corner

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Car drivers can breathe a sigh of relief after four tough months, as the price of crude oil, which accounts for 70% of retail gas prices, took a surprising plunge last week from $110 to $97 in just three days.

Average gas prices in the U.S. rose an astounding 80 cents in the first four months of 2011, but the crude oil roller coaster could be approaching another plunge. Economist James Hamilton predicts retail gas prices could drop as much as 40 cents a gallon.

Remember, the price of gas is determined mostly by supply and demand. A supply shock in Libya (which produces 2% of total oil supply) combined with rising demand from the developing world caused crude oil prices to increase 150% since 2009. But if other oil producing countries have the capacity to replace Libya's production in the next few months, the supply crunch might be short lived. And if China and the U.S. (~40% of worldwide oil demand) continue their slower-than-expected growth in 2011, we could really see prices begin to fall.

Hamilton explains:

In terms of what this means for American consumers, each $1/barrel change in the price of oil usually translates into 2.5 cents per gallon of gasoline at the pump. With the price of oil now down $16 from its peak, that might mean a drop of 40 cents per gallon in the retail price of gasoline.

Read the full story at Econobrowser. And remember, with oil prices fluctuating like a paper bag in a breeze, this is why the Federal Reserve doesn't base monetary policy off of gas prices.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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