Why Are Gas Prices So High?

High Gas Prices: Empty Tanks

In its February 2012 Short-Term Energy Outlook, the Energy Information Administration (EIA) forecasts that the annual regular-grade retail gasoline price will average around $3.55 per gallon in 2012 and $3.59 per gallon in 2013. During the April through September peak driving season each year, prices are forecast to average about 7 cents per gallon higher than the annual average with a high of $3.65 a gallon this summer. But today, gasoline prices are already higher than EIA’s average estimates at $3.72 a gallon according to AAA. These higher gas prices can be attributed to four main factors, the price of crude oil, federal and state taxes, refining costs, and the costs of distributing and marketing the gasoline.

CRUDE OIL PRICES

A majority of the price paid for a gallon of gasoline comes directly from the wholesale price of crude oil, which is refined to make gasoline and other petroleum products. In January 2012, the price of crude oil constituted 76 percent of the price of gasoline.

Crude oil is a globally-traded commodity. On net, the United States imports 45 percent of the crude oil it consumes.[1] The United States exports some crude oil and petroleum products due to geography and location and ownership of refineries. For example, the United States purchases crude oil from Canada and sells Canada a small amount of crude oil produced in Alaska. The United States purchases crude oil from Mexico and sells Mexico gasoline in return. Also, Venezuela owns three CITGO refineries in the United States and ships some of the products refined in the United States back to Venezuela.

While the precipitating causes behind spikes in crude oil prices have varied somewhat over time, the major driving forces behind the high per-barrel price at present are what everyone learns in Econ 101—supply and demand:

1. World Oil Demand Growth – World crude oil and liquid fuels consumption grew to the highest level ever in 2011, with an estimated 87.9 million barrels per day (bpd) consumed in total. The Energy Information Administration (EIA) projects that total world oil consumption will grow by 1.3 million bpd during 2012 and 1.5 million bpd in 2013 with countries outside the Organization for Economic Cooperation and Development (OECD) comprising most of the growth in consumption. Of the non-OECD countries, the largest increases come from China and the Middle East, who are using increasing amounts of oil to sustain their rapid economic growth.

China, in particular, has a large role in the increased global demand for oil. China is the second-largest consumer of oil behind the United States and as of 2009, China became the second-largest net importer of oil. In 2011, Chinese crude oil imports were 5.54 million bpd – up 8.2 percent from 2010 levels.

2. Domestic Supply – According to the EIA, the U.S. produced 5.67 million bpd of crude oil in 2011. The EIA expects production from the Federal Gulf of Mexico (GOM)—which produced 28 percent of U.S. oil in 2010—to fall by 90,000 bpd in 2012 on account of production declines from existing fields, the impact of the drilling moratorium, and the ensuing delay in issuing new drilling permits. Furthermore, crude oil production in Alaska is projected to fall by 20,000 bpd in both 2012 and 2013.

Onshore production in the lower 48 states, mainly on state and private lands, is increasing. The EIA expects onshore production to increase by 340,000 bpd in 2012 and 120,000 bpd in 2013, making up somewhat for the production losses offshore and in Alaska. Hydraulic fracturing technology that spurred domestic natural gas production is also increasing domestic oil production, particularly in North Dakota, which now may rank third among the states in oil production.

Some people argue that allowing more domestic offshore drilling would have little impact on oil prices. It is true that oil is a global commodity; however, after President Bush lifted the executive moratorium on July 14, 2008, and after Speaker Nancy Pelosi announced on September 23, 2008 that Congress would allow the congressional moratorium to expire, there were immediate price decreases. For example, prices dropped $9.26 per barrel – or 22 cents per gallon – on world markets during President Bush’s speech announcing the lifting of the moratorium. The chart below illustrates this effect:

Economic theory predicts that the potential for greater future oil production should lead to price relief. It is true that lifting the moratorium could not immediately increase oil production from the affected areas, but other oil producers with excess capacity, such as Organization of Petroleum Exporting Countries (OPEC) nations, would have an incentive to produce more in the present once they believe that future U.S. output will be higher. This example from 2008 is one example of oil price relief because of potential future oil production.

3. OPEC Production Restraints – About 25 percent of our oil product supply in 2011 arrived from the twelve OPEC countries: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela. These twelve oil-exporting nations possess much of the world’s known conventional oil reserves, and as such, have excess production capacity. However, in order to maintain favorably high oil prices, these nations agree on production targets that curtail the supply of oil from member states. For instance, in December 2008, the 11 members bound by quota restrictions, all but Iraq, agreed to a 4.2 million bpd production cut to keep oil prices high. In December 2011, OPEC agreed to a production ceiling of 30 million bpd that includes production from Iraq and the over production from some members that had been exceeding their quota. Oil prices, however, are remaining high due to unrest in the Middle East and the impending boycott of Iranian oil from the European Union in an attempt to make Iran abandon development of nuclear weapons.

4. U.S. Monetary Policy Weakening the Dollar – In 2008, commodity prices (like food and fuel) surged with the initial Federal Reserve interest rate cuts and increase in the monetary supply. This increase is precipitated by investors choosing to secure their finances with non-income generating real assets, like oil and precious metals, in the face of inflation and a devalued dollar. Unsurprisingly, oil prices have steadily risen in conjunction with Federal Reserve Chairman Ben Bernanke’s  increases in the money supply—referred to as quantitative easing or QE2. Oil prices surged along with other commodity prices when the Federal Reserve Board revved up its second burst of quantitative easing in 2010-2011 and stabilized when QE2 ended. In recent months, the Federal Reserve Board has again signaled its commitment to near-zero interest rates first through 2013, and then through 2014. Oil and other commodity prices have begun another surge and hedge funds are again betting on commodity plays.

FEDERAL & STATE EXCISE TAXES

The second main cost of the price of gasoline is federal and state taxes. In January 2012, federal, state and local taxes accounted for 12 percent of the price of gasoline. The federal tax on gasoline accounts for 18.4 cents per gallon, while the volume-weighted average state and local tax is 30.4 cents per gallon as of January 2012. This amounts to a 48.8 cent nationwide average tax on gasoline.

REFINING COSTS

The third cost to factor into the price of gasoline is the refining process, where crude oil is “cracked” and formulated into its chemical components and made into gasoline. In January 2012, refinery costs comprised 6 percent of the retail price of gasoline. This figure varies regionally because different parts of the country require different additives and processing steps in their gasoline formulations. The figure of 6 percent would also vary in other months, owing to seasonal changes in refinery operations. For example, in the spring when refineries need to retool to produce summer-blend gasoline and to meet summer gasoline demands, the cost of refinery operations is higher.

DISTRIBUTION AND MARKETING COSTS

The last and usually the smallest component of the price of gasoline is the retail dealer’s costs and profits, which constituted a combined 6 percent of the cost of a gallon of gasoline in January 2012. From the refinery, most gasoline is shipped first by pipeline to terminals near consuming areas, then loaded into trucks for delivery to individual stations. Ethanol must also be transported by truck or train since it cannot be mixed with gasoline prior to delivery by pipeline.

Even though many gas stations are branded as Shell, Exxon, BP or another major oil company, the major oil companies actually own less than 5 percent of gas stations. The vast majority of gas stations are actually independent businesses that purchase gasoline for resale to the public. In addition, some retail outlets are owned and operated by refiners.

The price at the pump reflects both the retailer’s purchase cost for the product and the other costs of operating the service station. It also reflects local market conditions and factors, such as the desirability of the location and the marketing strategy of the owner.