10/10/2014

What Determines Gas Prices?

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What Determines Gas Prices?

By Hans Wagner

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When gas prices start to rise, consumers certainly take note. However, although
many consumer express frustration over high gas prices, and even attempt to
pin the blame, most people have very little idea of how these prices come about.
Here we'll take a look at the factors that determine the price consumers pay at
the pump. (For background reading, see Understanding Oil Industry
Terminology..)
Terminology
Tutorial: Commodities 101
Oil Prices: The Crude Reality
According to the U.S. Department of Energy,
Energy, the price of crude oil averaged
68% of the average retail cost of gasoline in December of 2010. Federal and state
taxes were the next highest cost factor, averaging 14%, followed by refining
costs and profits, then distribution and marketing.
Between 2000 and 2007, the price of crude oil averaged 48% of the average
retail cost of gasoline from. Federal and state taxes were the next highest cost
factor, averaging 24%, followed by refining costs and profits, then distribution
and marketing.
Most people believe the price of oil is the primary determinate of the price of
gasoline, but the forces that influence gas prices are a bit more complicated than
the numbers suggest. To help understand how gas prices are set, it helps to
examine supply, demand, inflation and taxes. While supply and demand get the
most focus and the most blame for the high price of gasoline, inflation and taxes
also account for large increases in the cost to consumers. (To learn more, read
How Does Crude Oil Affect Gas Prices?)

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Supply and Demand
The basic rules of supply and demand have a predictable impact on the price of
gas. (For background information on these economic concepts, check out our
Economics Basics tutorial.)
Supply
Oil does not come out of the ground in the same form everywhere. It is graded
by its viscosity (light to heavy) and by the amount of impurities it contains
(sweet to sour). The price for oil that is widely quoted is for light/sweet crude.
crude.
This type of oil is in high demand because it contains fewer impurities and takes
less time for refineries to process into gasoline. As oil gets thicker, or "heavier,"
it contains more impurities and requires more processing to refine into gasoline.

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Light/sweet crude has been widely available and sought after in the past, but is
becoming harder to obtain. As the supply of this preferred oil becomes more
constrained, the price climbs. On the other hand, heavy/sour crude is widely
available through out the world. The price of heavy/sour crude is lower,
sometimes substantially lower, than light/sweet crude.

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Refining heavy/sour crude requires a higher capital investment to process

lower-quality oil. This investment is possible since refiners can purchase
poorer-quality crude at a lower price so they can get their return on investment.
(For more information on the cost of oil, read What Determines Oil Prices?)

Demand
Change in the demand for gasoline is
primarily set by the number of
people who are using the fuel for
transportation. The growth in the
number of people driving cars and
trucks, particularly in parts of the
developing world, has expanded
dramatically in the last few years.
China and India, each with a
population in excess of 1 billion, are
experiencing an expanding middle class that will likely use more gasoline over
time.

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10/10/2014

What Determines Gas Prices?

China is building 42,000 miles of new interprovincial express highways by 2020

to accommodate the all the new car sales in that country. By comparison, the
U.S. has about 86,000 miles of interstate highways. India has plans to construct
another 12,000 miles of expressways by 2022. Cars driving on those highways
are going to consume more gasoline, creating more demand for fuel. (Read
about how industrialization can be good news for your portfolio in Build Your
Portfolio With Infrastructure Investments.)
Many countries subsidize the retail price of gasoline to encourage industrial
development and to gain the popular support of the people, creating an
artificially higher demand for gasoline. Changes in this subsidy will affect the
demand for gas similarly to price increases or price decreases.

Creating Balance
Prices help to allocate scarce goods. Although demand for gasoline is more
elastic in the long term, small disparities in supply and demand in either
direction will have a large impact on prices in the short run. This inelasticity of
demand means if prices go up, demand goes down, but not by very much. The
problem is that people are locked into their existing life patterns for the near
term. While they can change their fuel consumption by buying more fuelefficient vehicles or moving closer to work, these things take time. (One option,
hybrid cars, has gained popularity in recent years. Read Hybrids: Financial
Friends Or Foes? to learn more.)
On the other hand, the expansion of new middle classes throughout the world
will cause a growing demand for gasoline as they create new life patterns that
include driving cars. Price will balance supply of gasoline with demand, and the
global market for gasoline provides the forum for establishing that balance.
Inflation And Taxes
Inflation and taxes account for the biggest relative increases in the price of
gasoline.

Inflation
Inflation is the general rate at which prices of goods/services are rising (and,
conversely, the rate at which purchasing power is falling). In the U.S., an item
that cost $1 in 1950 would cost about $9.30 in 2010. In 1950, gas cost about 30
cents per gallon. Adjusting for inflation, a gallon of gas should cost about $2.79,
assuming taxes, supply and demand stayed the same. The level of inflation
varies by country, which can influence the price of fuel. (To learn more about
inflation, read our All About Inflation Tutorial.)
Taxes
The tax on a gallon of gas in 1950 was approximately 1.5% of the price. In 2011,
the federal, state and local tax on a gallon of gasoline was approximately 20% of
the total price. This means that taxes added about 48 cents to the price increase
in a gallon of gas. Federal tax made up 18.4 cents, state tax made up 20.6 cents,
and local and other taxes made up 9 cents per gallon as of January of 2011.
Other countries have vastly different tax policies for gasoline, some of which
can make taxes the largest price component.

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What Determines Gas Prices?

Cumulative Effects
As a point of reference, inflation and taxes added approximately $2.83 to the
rise in the price of gasoline over the 58-year period from 1950 to 2008. It is
important to have this perspective when considering the impact of supply and
demand on the price of gasoline.
The Bottom Line
Over the short term, as prices rise or fall, demand tends to be relatively
inelastic. People only make small changes in their consumption of gasoline
when there are large changes in the price, and this pattern helps balance the
supply and demand of gasoline.
Over time, we can expect to see a movement toward lower fuel consumption at
the individual level, but an increase in the number of people who depend on
gasoline worldwide. These changes will no doubt impact the price we pay at the
pump.
While there is a common belief that the price of gasoline is solely determined
by the supply and demand of crude, several other important factors come into
play as well. Taxes, depending on the country, can add substantially to the retail
price of gasoline. Over time, inflation also results in higher gas prices.
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