The Risks of Falling Gas Prices

Smart investors know all about the "suckers' rally"—a temporary pause in a downward trend that amateurs mistake as a turnaround. Motorists might have to get used to the phenomenon, too.

There's a national sigh of relief as oil prices fall and the cost of gasoline drifts down from record highs. Since peaking on July 17 at $4.11 per gallon, gas prices have dropped about 25 cents. Some analysts think fuel prices have a lot farther to fall. If so, it would be a welcome breather for a gasping economy.

But drivers probably shouldn't count on it. There's just as much reason for gas prices to go back up as to fall. Oil is obviously a volatile commodity, and it's prudent to plan for a worst-case scenario, not a best case. Plus, falling gas prices could reverse a few positive trends that have started Americans down the road toward energy independence. Reasons to be cautious:

There have been several false peaks in gas prices. Gas prices spiked and drifted down several times over the last couple of years, only to reverse course and soar even higher. A jagged line graph of gas prices tells the tale: In the summer of 2006, pump prices crossed the $3 threshold, then fell to as low as $2.20 or so. Then they popped up to $3.20 in May 2007, before falling back below $3 for much of 2007. Then the first half of 2008 saw the huge run-up that peaked at $4.11. Now we're in another downswing.

Maybe $4.11 will really turn out to be the peak, and it's downhill from here. But there's nothing magical about $4.11, and many analysts thought $3 would be the peak. Then $3.20. So pick your expert. Some think oil prices will fall another 50 percent; others think much steeper price hikes are ahead. General Motors marketing chief Mark LaNeve told me recently that GM assumes $4 gas is here to stay. Strategic planners at Toyota, where conservative assumptions have paid off handsomely, think gas prices could rise to $5 or even $6 by 2010. Both automakers are locking in long-term plans based on those assumptions. Betting on the opposite seems awfully risky.

A resurgent economy could push prices right back up. For a while, rising gas prices perplexed analysts: Usually, gas prices fall when the U.S. economy sags, because demand drops. That correlation didn't occur in the first half of 2008, but it is happening now.

Americans have finally started fleeing big vehicles en masse, and they're driving less, too. U.S. gas consumption will probably fall this year for the first time in decades. And lo and behold, gas prices are finally falling in tandem.

Eventually, the U.S. economy will regain its strength. Meanwhile, vibrant economies in China and India—a new factor creating upward pressure on oil prices—will keep growing. If basic economics hold, oil demand will once again rise robustly, and prices along with it.

Downsizing makes sense no matter how much gas costs. For families with kids and other people with heavy hauling needs, there may not be much alternative to a minivan or big crossover that can carry seven. But lots of others can downsize without any real tradeoffs. Smaller cars are often more nimble and fun to drive and easier to maneuver in parking lots. Some have features like folding rear seats and all-wheel drive that make them almost as practical as SUVs. By definition, smaller engines with higher MPG pollute less than bigger engines, an appealing attribute to more and more consumers.

There's little harm in preparing for the worst. If you think gas prices will stay high or go higher, the next car you buy is likely to be a thrifty model that gets good mileage. What if you guess wrong, and gas falls back to $2 per gallon? Well, you'll still get good mileage and save money. Downsides: Your car might not be as fast as it could be, or as spacious, or as luxurious. You'll live.

Cheap gas perpetuates our oil addiction. With gas at $2 or $2.50, there's not much incentive for people to buy hybrids or for automakers to invest in technologies that could someday replace gasoline. Oil carries the day, and we pump with abandon. That's the pattern that played out after the energy crisis in the 1970s: As gas prices skyrocketed, automakers spent billions on ways to improve mileage. But they largely abandoned those efforts when gas prices came back down, drivers upsized, and efficiency fell out of favor.

At $4, gas prices cause more pain, which strengthens the market for fossil-fuel alternatives. And automakers are in fact in a technology race to field the first plug-in hybrids, electric cars, and hydrogen-powered vehicles. The more costly gas becomes, the sooner those alternatives will arrive. And the better they'll be.

Ordinary consumers can't do anything to raise or lower gas prices. But they can make purchase decisions, and drive their cars, as if costly gas is the new normal. Even if that's not the case today, it could be tomorrow. Just like yesterday. Remember?