Originally Published: 5/3/2006
THE PRICE OF GAS
By The Issue Wonk
How is the price of gasoline determined? What are we paying for? Gasoline comes from crude oil. The price of crude oil is what we hear about when we hear the price of a “barrel.” Then there’s the cost of refining the crude into gasoline, taxes, and distribution costs.
Crude Oil. Refiners buy crude oil and “refine” it into gasoline (among other things). WTRG Economics1 states that crude oil “ranged between $2.50 and $3.00 from 1948 through the end of the 1960s.” In 2004 dollars this is $15.00 to $17.00. In 2003 the average cost for crude oil was $28.50 per barrel and in 2004 in was $36.97 per barrel.2 Now, as we all know, the price per barrel is over $70.00. Crude oil prices are primarily determined by worldwide supply and demand.
Supply: The Organization of Petroleum Exporting Countries (OPEC)3 exerts considerable influence on the supply of crude oil since its members produce about 40% of the world’s production and thus can control how much crude is released to the market.2 Increased costs have been associated with market disruptions, such as “the Arab oil embargo in 1973, the Iranian revolution in 1978, the Iran/Iraq war in 1980, and the Persian Gulf conflict in 1990.” We can add to that the current Iraq war. It is also interesting to note that the U.S. is in conflict, either militarily or politically, with many of OPEC’s members.
Demand: According to the Congressional Research Service (CRS), in 2004 the U.S. demand for gasoline was increasing by 500,000 barrels per day.4 And, according to Phil Flynn, senior market analyst at Alaron Trading Corp., Americans have been burning an additional 9.1 million barrels a day over the last 4 weeks compared with the same period last year.5 There is also a huge worldwide demand by expanding countries, such as India and China. In addition, CRS stated that, since U.S. refineries did not add capacity to meet this demand, the market turned to imported gasoline, putting further pressure on worldwide demand. And, the demand for higher quality gasoline increased as “specifications for environmentally acceptable fuel have become more stringent.”4
Refining Costs. Refining costs will vary due to the different grades and formulations required in different parts of the country. Hurricane Katrina reportedly took out 10% to 15% of U.S. refining capacity.2 According to White, “some Gulf Coast refineries remain hobbled by hurricane damage and others are in the middle of longer-than-usual annual tuneups. Many refiners put off their regularly scheduled maintenance last year to rebuild supplies after the hurricanes. The American Petroleum Institute said that U.S. refiners operated at 86.7% of capacity in March (2006), down from 90.2% during the same month in 2005.” Additionally, some refineries are “adjusting to more stringent low-sulfur fuel requirements and the phase-out of the gasoline additive MTBE.”6
Taxes. Federal, state, and local taxes are also included in the cost of gas. Currently federal taxes are 18.4 cents per gallon (cpg). States vary widely. As of January 2005, the lowest was Virginia at 7 cpg, with an additional 4% sales tax. Wyoming was at 14 cpg with no sales tax, and New York was at 31.9 cpg. Several states levy sales and other taxes in addition to a gas tax. Also, there may be county and city taxes. The only way to know for sure what you’re paying in tax is to check your local taxes.7
Distribution. Gasoline is delivered from the oil refiners to the public primarily through pipelines to terminals then loaded into trucks for delivery to individual gas stations. According to National Petroleum News, in 2005 there were approximately 168,987 retail gasoline stations throughout the United States.8 Some of these stations are owned and operated by refiners (like ExxonMobil) while others are independent and purchase gasoline for resale to the public. The cost per gallon reflects the cost of operating the service station as well as other local business conditions. In addition, a region’s proximity to its supplier influences the cost of obtaining gasoline. “Areas farthest from the Gulf Coast (the source of nearly half of the gasoline produced in the U.S. and, thus, a major supplier to the rest of the country), tend to have higher prices.”2
Other Factors. There are numerous other factors that may effect the cost of gasoline: futures trading, inventories at U.S. refineries, the Strategic Petroleum Reserve, and corporate profits.
Futures Trading: Crude oil is not bought in a store, it’s purchased on the futures market. Oil companies purchase crude or invest in oil fields by bidding to purchase at a future date for a certain amount. For example, if last year they bid at $40.00 per barrel, that’s the price they are now paying, but it’s worth over $70.00 per barrel. A nice profit. (If the price of oil had suddenly dropped to, say, $20.00 per barrel, they would be posting losses.) Indeed, much of the oil companies’ profits can probably be attributed to this. However, they aren’t the only ones speculating on the price of oil. Hedge funds and other speculators are investing, too. And, just like stocks, when there is heavy buying, prices go up. According to Mouawad and Timmons:
On Nymex, oil contracts held mostly by hedge funds – essentially private investment vehicles for the wealthy and institutions, run by traders who share the risks and rewards with their partners – rose above one billion barrels this month (April 2006), twice the amount held five years ago. Beyond that, trading has also increased outside official exchanges, including swaps or over-the-counter trades conducted directly between, say, a bank and an airline. And that comes on top of the normal trading long conducted by oil companies, commercial oil brokers or funds held by investment banks. “Five years ago, our futures exchange was a small group of physical oil players,” said Jeffrey Sprecher, the chief executive of Intercontinental Exchange, the Atlanta-based electronic exchange where about half of all oil futures are traded. “Now there are all sorts of new investors in trading commodity futures, much of which is backed by pension fund money.”9
Inventories: Gasoline and crude oil inventories, if low, will help drive up the price of gas. Of course, the availability of oil for refining is effected by its cost and availability as well as its usage.
Strategic Petroleum Reserve: According to the U.S. Department of Energy, the U.S. Strategic Petroleum Reserve is the “largest stockpile of government-owned emergency crude in the world.” While the amount of crude in reserves probably has little, if any, impact on the price of gas, politicians frequently propose releasing some of the reserves onto the market in an effort to increase supply and, thus, drive down prices. However, “using the Strategic Petroleum Reserve as a lever against higher prices – has been tried repeatedly by Bush and several of his predecessors, with little if any effect.”10
Corporate profits: First quarter 2006 profits for oil companies have been soaring. ExxonMobil, Chevron, and ConocoPhillips, together, reported profits of $15.7 billion, “a nearly 17% increase from the first quarter 2005 profits.”11 Some cite these huge profits as proof that the oil companies are raking in the bucks at the expense of consumers. However, it’s more likely that the incredible profits are due to the futures market. According to Horsley, crude oil production accounts for more than 75% of ExxonMobil’s profits during the first quarter 2006.12 The oil companies “invested in oil fields when prices were much lower.”5 Thus, at the time of purchase, they expected to “break even” when oil was at $25.00 per barrel. Since the market has risen to more than $70.00 per barrel, they have made a profit. They cannot control the price of the crude, but if demand is high and supply is low and they have invested at a low rate, when prices increase, they profit. The issue of a windfall profits tax on the oil companies has arisen in the past but has not gotten much wind (pun intended). The theory is that if oil companies have to pay additional taxes on their profits, they will keep the profits lower and, thus, keep the prices down. The oil companies argue that additional taxes would keep them from investing their profits in new oil fields or refineries and, thus, would not lower prices. One proposal, by Senator Byron Dorgan (D, ND), would have taxed only those windfall profits that were not reinvested.
What are the solutions? This isn’t a difficult question. You either increase the supply or you decrease the demand. Simple.
1 For the history of crude oil, please see WTRG Economics.
2 Energy Information Administration, Official Energy Statistics from the U.S. Government.
3 OPEC members are: Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela.
4 Gasoline Price Surge Revisited: Crude Oil and Refinery Issues, Congressional Research Service, April 8, 2004.
5 White, Ronald D. “Supply Fears, Speculators Pumping Up Oil Prices,” Los Angeles Times, April 24, 2006.
6 Horsely, Scott. “Q&A: What’s Behind High Gas Prices?” National Public Radio, April 27, 2006.
7 See Gas Price Watch.
8 National Petroleum News, “Annual Station Count Slowly Regains Lost Numbers,” May 2005.
9 Mouawad, Jad & Timmons, Heather. “Trading Frenzy Adding to Rise in Price of Oil.” The New York Times, April 29, 2006.
10 Wallsten, Peter & Simon, Richard. “Bush’s Proposals Viewed as a Drop in the Oil Bucket.” Los Angeles Times, April 26, 2006.
11 Douglass, Elizabeth. “Chevron Posts 49% Increase in Profit.” Los Angeles Times, April 29, 2006.
12 Horsely, Scott. “Record Profits at Oil Companies Draw Criticism.” National Public Radio, April 27, 2006.
© The Issue Wonk, 2006