10/10/2014 What Determines Gas Prices?

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When gas prices start to rise, consumers certainly take note. However, althoughWhen gas prices start to rise, consumers certainly take note. However, although

many consumer express frustration over high gas prices, and even attempt tomany 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.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 atHere we'll take a look at the factors that determine the price consumers pay at

the pump. (For background reading, see the pump. (For background reading, see Understanding Oil IndustryUnderstanding Oil Industry

TerminologyTerminology..))

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Oil Prices: The Crude RealityOil Prices: The Crude Reality

According to the According to the U.S. Department of EnergyU.S. Department of Energy, the price of crude oil averaged, the price of crude oil averaged

68% of the average retail cost of gasoline in December of 2010. Federal and state68% 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 refiningtaxes were the next highest cost factor, averaging 14%, followed by refining

costs and profits, then distribution and marketing.costs and profits, then distribution and marketing.

Between 2000 and 2007, the price of crude oil averaged 48% of the averageBetween 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 costretail cost of gasoline from. Federal and state taxes were the next highest cost

factor, averaging 24%, followed by refining costs and profits, then distributionfactor, averaging 24%, followed by refining costs and profits, then distribution

and marketing.and marketing.

Most people believe the price of oil is the primary determinate of the price ofMost 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 thangasoline, 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 tothe numbers suggest. To help understand how gas prices are set, it helps to

examine supply, demand, inflation and taxes. While supply and demand get theexamine 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 taxesmost 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, readalso account for large increases in the cost to consumers. (To learn more, read

How Does Crude Oil Affect Gas Prices?)How Does Crude Oil Affect Gas Prices?)

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What Determines Gas Prices?What Determines Gas Prices?

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10/10/2014 What Determines Gas Prices?

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Supply and DemandSupply and Demand

The basic rules of The basic rules of supplysupply and and demanddemand have a predictable impact on the price of have a predictable impact on the price of

gas. (For background information on these economic concepts, check out ourgas. (For background information on these economic concepts, check out our

Economics BasicsEconomics Basics tutorial.) tutorial.)

SupplySupply

Oil does not come out of the ground in the same form everywhere. It is gradedOil 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 containsby 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 (sweet to sour). The price for oil that is widely quoted is for light/sweet crudelight/sweet crude..

This type of oil is in high demand because it contains fewer impurities and takesThis type of oil is in high demand because it contains fewer impurities and takes

less time for refineries to process into gasoline. less time for refineries to process into gasoline. As oil gets thicker, or "heavier,"As oil gets thicker, or "heavier,"

it contains more impurities and requires more processing to refine into gasoline.it contains more impurities and requires more processing to refine into gasoline.

Light/sweet crude has been widely available and sought after in the past, but isLight/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 morebecoming harder to obtain. As the supply of this preferred oil becomes more

constrained, the price climbs. On the other hand, constrained, the price climbs. On the other hand, heavy/sour crudeheavy/sour crude is widely is widely

available through out the world. The price of heavy/sour crude is lower,available through out the world. The price of heavy/sour crude is lower,

sometimes substantially lower, than light/sweet crude.sometimes substantially lower, than light/sweet crude.

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

lower-quality oil. This investment is possible since refiners can purchaselower-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.poorer-quality crude at a lower price so they can get their return on investment.

(For more information on the cost of oil, read (For more information on the cost of oil, read What Determines Oil Prices?What Determines Oil Prices?))

DemandDemand

Change in the demand for gasoline isChange in the demand for gasoline is

primarily set by the number ofprimarily set by the number of

people who are using the fuel forpeople who are using the fuel for

transportation. The growth in thetransportation. The growth in the

number of people driving cars andnumber of people driving cars and

trucks, particularly in parts of thetrucks, particularly in parts of the

developing world, has expandeddeveloping world, has expanded

dramatically in the last few years.dramatically in the last few years.

China and India, each with aChina and India, each with a

population in excess of 1 billion, arepopulation in excess of 1 billion, are

experiencing an expanding middle class that will likely use more gasoline overexperiencing an expanding middle class that will likely use more gasoline over

time.time.

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China is building 42,000 miles of new interprovincial express highways by 2020China 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, theto 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 constructU.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 highwaysanother 12,000 miles of expressways by 2022. Cars driving on those highways

are going to consume more gasoline, creating more demand for fuel. (Readare going to consume more gasoline, creating more demand for fuel. (Read

about how industrialization can be good news for your portfolio in about how industrialization can be good news for your portfolio in Build YourBuild Your

Portfolio With Infrastructure InvestmentsPortfolio With Infrastructure Investments.).)

Many countries subsidize the retail price of gasoline to encourage industrialMany countries subsidize the retail price of gasoline to encourage industrial

development and to gain the popular support of the people, creating andevelopment and to gain the popular support of the people, creating an

artificially higher demand for gasoline. Changes in this subsidy will affect theartificially higher demand for gasoline. Changes in this subsidy will affect the

demand for gas similarly to price increases or price decreases.demand for gas similarly to price increases or price decreases.

Creating BalanceCreating Balance

Prices help to allocate scarce goods. Although demand for gasoline is morePrices help to allocate scarce goods. Although demand for gasoline is more

elasticelastic in the long term, small disparities in supply and demand in either 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 direction will have a large impact on prices in the short run. This inelasticityinelasticity of of

demand means if prices go up, demand goes down, but not by very much. Thedemand 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 nearproblem is that people are locked into their existing life patterns for the near

term. While they can change their fuel consumption by buying more fuel-term. While they can change their fuel consumption by buying more fuel-

efficient vehicles or moving closer to work, these things take time. (One option,efficient vehicles or moving closer to work, these things take time. (One option,

hybrid cars, has gained popularity in recent years. Read hybrid cars, has gained popularity in recent years. Read Hybrids: FinancialHybrids: Financial

Friends Or Foes?Friends Or Foes? to learn more.) to learn more.)

On the other hand, the expansion of new middle classes throughout the worldOn 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 thatwill 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 theinclude driving cars. Price will balance supply of gasoline with demand, and the

global market for gasoline provides the forum for establishing that balance.global market for gasoline provides the forum for establishing that balance.

Inflation And Taxes Inflation And Taxes

Inflation and taxes account for the biggest relative increases in the price ofInflation and taxes account for the biggest relative increases in the price of

gasoline.gasoline.

InflationInflation

InflationInflation is the general rate at which prices of goods/services are rising (and, is the general rate at which prices of goods/services are rising (and,

conversely, the rate at which conversely, the rate at which purchasing powerpurchasing power is falling). In the U.S., an item 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 30that 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,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 inflationassuming taxes, supply and demand stayed the same. The level of inflation

varies by country, which can influence the price of fuel. (To learn more aboutvaries by country, which can influence the price of fuel. (To learn more about

inflation, read our inflation, read our All About Inflation TutorialAll About Inflation Tutorial.).)

TaxesTaxes

The tax on a gallon of gas in 1950 was approximately 1.5% of the price. In 2011,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% ofthe 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 increasethe 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,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.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 whichOther countries have vastly different tax policies for gasoline, some of which

can make taxes the largest price component.can make taxes the largest price component.

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Cumulative EffectsCumulative Effects

As a point of reference, inflation and taxes added approximately $2.83 to theAs 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 isrise 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 andimportant to have this perspective when considering the impact of supply and

demand on the price of gasoline.demand on the price of gasoline.

The Bottom LineThe Bottom Line

Over the short term, as prices rise or fall, demand tends to be relativelyOver the short term, as prices rise or fall, demand tends to be relatively

inelastic. People only make small changes in their consumption of gasolineinelastic. People only make small changes in their consumption of gasoline

when there are large changes in the price, and this pattern helps balance thewhen there are large changes in the price, and this pattern helps balance the

supply and demand of gasoline.supply and demand of gasoline.

Over time, we can expect to see a movement toward lower fuel consumption atOver 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 onthe 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 thegasoline worldwide. These changes will no doubt impact the price we pay at the

pump.pump.

While there is a common belief that the price of gasoline is solely determinedWhile 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 intoby 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 retailplay 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.price of gasoline. Over time, inflation also results in higher gas prices.

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