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Q&A: Why are gasoline prices so high?

Thursday, March 22, 2012 | 1:39 p.m. CDT

NEW YORK — Watching the numbers on the gas pump tick ever higher can boil the blood and lead the mind to wonder: Why are gasoline prices so high?

Many stand accused, including oil companies, the president, Congress, and speculators on Wall Street. Others assume that the earth is just running out of oil.

The reality, economists say, is fairly simple, but it isn't very satisfying for a driver looking for someone to blame for his $75 fill-up. Last year, the average price of gasoline was higher than ever, and it hasn't gotten any better this year. The average price nationwide is $3.88 per gallon, the highest ever for March. Ten states and the District of Columbia are paying more than $4.

Q: What determines the price of gasoline?

A: Mainly, it's the price of crude oil, which is used to make gasoline. Oil is a global commodity, traded on exchanges around the world. The main U.S. oil benchmark has averaged $103 per barrel this year. The oil used to make gasoline at many U.S. coastal refineries has averaged $117 per barrel.

Oil prices have been high in recent months because global oil demand is expected to reach a record this year as the developing nations of Asia, Latin America and the Middle East increase their need for oil. There have also been minor supply disruptions in South Sudan, Syria and Nigeria. And oil prices have been pushed higher by traders worried that nuclear tensions with Iran could lead to more dramatic supply disruptions. Iran is the world's third largest exporter.

Q: How are gasoline prices set?

A: When an oil producer sells to a refiner, they generally agree to a price set on an exchange such as the New York Mercantile Exchange. After the oil is refined into gasoline, it is sold by the refiner to a distributor, again pegged to the price of wholesale gasoline on an exchange.

Finally, gas station owners set their own prices based on how much they paid for their last shipment, how much they will have to pay for their next shipment, and, perhaps most importantly, how much their competitor is charging. Gas stations make very little profit on the sale of gasoline. They want to lure drivers into their convenience stores to buy coffee and soda.

Oil companies and refiners have to accept whatever price the market settles on — it has no relation to their cost of doing business. When oil prices are high, oil companies make a lot of money, but they can't force the price of oil up.

Q: Are oil prices manipulated by speculators on Wall Street?

A: Investment in oil futures contracts by pension funds, mutual funds, hedge funds, exchange traded funds and other investors who aren't going to actually use oil has risen dramatically in the last decade. Much of this money is betting that oil prices will rise. It is possible that this has inflated the price of oil — and therefore gasoline — somewhat. But investors can also bet that prices will go down, and they do. Studies of the effects of speculation on oil markets suggest that it probably increases volatility, but that it doesn't have a major effect on average prices.

Q: Are politicians to blame for high prices?

A: Politicians can't do much to affect gasoline prices because the market for oil is global. Allowing increased drilling in the U.S. would contribute only small amounts of oil to world supply, not nearly enough to affect prices. The Associated Press conducted a statistical analysis of 36 years of monthly inflation-adjusted gasoline prices and U.S. domestic oil production and found no statistical correlation between oil that comes out of U.S. wells and the price at the pump. Over the last three years, domestic oil production has risen and gasoline prices rose sharply. In the 1980s and 1990s, U.S. production fell dramatically, and prices did too.

Releasing oil from emergency supplies held in the Strategic Petroleum Reserve could lead to a temporary dip in prices, but the market might instead take it as a signal that there is even less oil supply in the world than thought, and bid prices higher. Any price relief from a release of reserves would be temporary.

Politicians can, however, help reduce the total amount drivers pay at the pump. They could lower gasoline taxes and they can help get more fuel efficient cars into showrooms by mandating fuel economy improvements or subsidizing the cost of alternative-fueled vehicles. The first new fuel economy standards since 1990 are just now going into effect. Last summer the Obama Administration and automakers agreed to toughen standards further in 2016.

The U.S. fleet is now more fuel efficient than ever, and gasoline demand in the U.S. has fallen for 52 straight weeks. The U.S. is never again expected to consume as much gasoline as it did in 2006. That means that while drivers are paying more than they used to, they would have been paying much more if they consumed as much gasoline as they did in the middle of the last decade.

Q: Are prices high because the world is running out of oil?

A: Not yet. Prices are high because there's not a lot of oil that can be quickly and easily brought to market to meet demand or potential supply disruptions from natural disasters or political turmoil. Like most commodities, the need for oil is so great that people will pay almost anything, in the short term, to get their hands on what might be the last available barrel at any given moment.

But substantial new reserves of oil have been found in shale formations in the United States, in the Atlantic deep waters off of Africa and South America, and on the east coast of Africa. Canada has enormous reserves, and production is growing fast there. The Arctic, which is largely unexplored, is thought to have 25 percent of the world's known reserves.

All of this oil, however is hard to get and expensive to produce. That leads analysts to believe that oil will never stay much below $60 a barrel for an extended period again. As soon as oil prices fall, producers will stop developing this expensive oil until demand, and high prices, return. Current high prices have fueled a boom in oil exploration that is sure to bring more crude to the market in coming years. But it is not here yet, so for now, pump prices — and frustration — are expected to remain high.


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Comments

Mark Foecking March 22, 2012 | 1:55 p.m.

Another excellent article. If gas prices are a problem for you, make choices that reduce your need for gasoline.

If you're a business, you'll have to pass the price along until you can make changes to use less gasoline. Chances are the competition uses just as much gasoline as you do.

Gasoline use is a choice. 80% of all energy use is a choice. It's just as easy to choose to use less than it is to blame the oil companies or Washington, and a whole lot more effective.

DK

(Report Comment)
Michael Williams March 22, 2012 | 3:21 p.m.

The article says, "Finally, gas station owners set their own prices based on how much they paid for their last shipment, how much they will have to pay for their next shipment, and, perhaps most importantly, how much their competitor is charging."
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Now that's just a bunch of malarkey and such an obvious misstatement causes concerns about the accuracy of the rest of the article. Whole cities, including Columbia, have EXACTLY the same price of gas at EVERY station, down to the penny.

(Report Comment)
Greg Allen March 22, 2012 | 3:44 p.m.

Follow the money. Who's making the most money off of the price of gas? That's who's setting the prices.

Maybe I'm getting old, but I just had to shake my head today when it took forty dollars to fill the tank in my economy car. Doesn't help to get mad about what's so ridiculous and beyond my control, though.

(Report Comment)
Michael Williams March 22, 2012 | 4:17 p.m.

There is NO price competition for gasoline in Columbia, MO.

I'd like to know why.

(Report Comment)
Mark Foecking March 23, 2012 | 6:12 a.m.

Michael, I don't buy much gas so take this for what it's worth, but there are a few stations that have different prices. The Shell on I-70 SW near Business Loop, the Sinclair at Stadium and Rollins, and the Phillips on West Blvd are some I've noticed buck the trend. I understand it's that MFA operates 90% of the filling stations around town and sets the prices centrally. I also believe, though I haven't checked in a while, that the stations I mentioned also offer 93 octane gasoline, where the MFA stations don't, indicating a different supplier.

I observe in St. Louis and Tampa, FL, there's more price diversity than Columbia.

The rest of the article jives with some of the other stuff I read from many sources. No one thing is responsible for the price of gasoline, and it's not something anyone can do a lot about.

DK

(Report Comment)
Michael Williams March 23, 2012 | 9:00 a.m.

I buy in Old Franklin going to-and-from the farm. Always cheaper, usually by several cents. I haven't bought gas near Columbia in years unless I'm running on my last nanomole, a rare occurrence, and then only buy enough to get someplace else. Does the local Sinclair still pump for you? If so, that would explain at least one difference. I can certainly attest that "competition" today is not even close to the "competition" of yesteryear.

I also think you are right about central price setting. I've talked to several station owners, and they do NOT set the price. In places I go, the article is dead wrong on this particular issue. I don't know if it is wrong about other things or not.

I was reading an article about Delta Airlines the other day (where?). The CEO of that company was asked what kept him up at night. He replied, "The Strait of Hormuz".

It would be better to not depend upon that narrow body of water, on that I think you and I would agree.

(Report Comment)
John Schultz March 25, 2012 | 11:03 p.m.

Michael, I believe the gas prices in Columbia are relatively clustered since a vast majority of stations get their gas from the pipeline facility across 63 from KOMU.

(Report Comment)
Michael Williams March 26, 2012 | 8:40 a.m.

JohnS: Yes, I've heard the same thing.

My original criticism to this article was the statement: "Finally, gas station owners set their own prices based on "...how much their competitor is charging."

For this area, that statement is just plain false.
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Centralization is certainly the norm and has a leveling effect on prices. You seldom see "brand name" trucks, only generic ones delivering from a central terminal.

As posted, I've talked to several station managers. They get a phone call, and the prices promptly change. The station managers are not calling the shots on price, but no one will tell me who is on the other end of the phone line, so I don't know if it's local or non-local.
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Folks often ask "Why does the price of gas go up so fast when barrel oils prices go up, but only go down slowly when the price per barrel drops?"

If you are a retailer and purchase 1000 gallons of wholesale gas at...say...3 bucks/gallon, you just paid $3000. Now, you have to sell that gas at an elevated price...say, $3.10/gallon...to make your gross profit, in this case $100 on the entire load.

Now, while you're holding and selling that 1000 gallon inventory, the wholesale price goes up to $3.20/gallon. Let's pretend you are a kindly sort of station manager (although not particularly financially astute), and you keep selling your gas retail at $3.10/gallon. When your inventory is gone, you have $3100. It's time to buy more inventory. Big problem: It costs $3200 to buy your new inventory, your $100 gross profit is gone, and you can only purchase 968.75 gallons of new inventory with that money. Your tanks aren't full because you did not respond upwards to the wholesale price when you already had your $3000 gallon inventory.

What about the reverse? You purchase 1000 gallons wholesale at $3.00/gallon, equaling $3000. You start selling at $3.10/gallon, as before. The wholesale price drops to $2.90/gallon in the interim. What do you do?

Well, you could drop your retail price promptly to $3.00/gallon, but now you are making NO gross profit whatsoever while you are holding/selling your current inventory. You still have payroll and expenses to meet from that gross profit, too. The result? Prices come down more slowly because you have bills to pay. If wholesale prices stick to $2.90/gallon, you indeed will be able to purchase more than 1000 gallons of profit (or pocket more profit) when you buy new inventory, but the "time value" factor of money comes into play because you had to delay your gross profit for the next inventory cycle.

This is a simplistic analysis which certainly has faults of which I am unaware. All I'm sure of is I wouldn't want to be in the business of trying to set retail prices in a volatile wholesale market. I like being more "sedate" in my life.

Comments/errors?

(Report Comment)
Jonathan Hopfenblatt March 26, 2012 | 12:03 p.m.

I'm pretty much illiterate on all things oil-related, but it's not necessarily true that gas station owners can't be setting the price themselves if prices everywhere are all approximately the same. Undercutting the competition is the obvious way to steer the clientele your way, but doing so would motivate someone else to return the favor, and so on it would go until eventually everyone's losing money big time.

I'm sure a game theorist could flesh this out a lot better, but however counterintuitive it might sound, a lot of times the best thing to do in this kind of situation is to "play nice" with the competition, and essentially not compete.

Plus, I know from personal experience that gas prices from one station to the next can be very different even if it doesn't seem that way in places like Columbia. Go to any gas station near a major airport and you'll see prices nearing $6 a gallon. Drive a mile or so away from the airport and it's half that.

(Report Comment)

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