Gas Prices — how do they work?

From AP:

NEW YORK (AP) – 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.

Jonathan Fahey can be reached at .


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  • DanK

    We have $6.20 USD per gallon (at the current conversion rates) down here in Oceania.

  • Joe Canner

    Can we make this required reading for all registered voters who intend to vote in the general election? Just thinking about the fact that there are people who are going to vote a certain way because of the price of gas makes my blood pressure go up.

  • Ann F-R

    Note: I did a bit of background research on Fahey, because his answer to the question about Wall St. speculation affecting commodity prices (in this case, oil’s price) hasn’t been borne out by economic analyses that I’ve read. I found this bit of bio at Forbes where he used to write, prior to AP: Other articles show up in energy industry news sites, but not in economic analysis. That may signify a problem w/ his answers.

    So, I did some research specifically looking for reputable sources of economic analysis: The St Louis Fed had a premier economic research dept w/ excellent statistical analysis when I worked for the FRB. Everything I’ve seen since that time still seems to reflect that history. The authors of the study I linked – which came out just this month – do not agree w/ Fahey’s assertion that “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.” What constitutes NOT a “major effect” to Fahey? Why would he minimize the effects of market speculation, and non-industry related players trading on volatile commodities exchanges? (i.e., players who have no interest in holding the contracts [they are not consumers nor suppliers of the commodity], but rather use the volatility of the commodity to their financial advantage. The more volatile the market, the greater the chances fast traders w/ insider info or technical advantage have of making money off pricing differentials.)

    I’d guess, if anything, the Federal Reserve Bank of St Louis underestimates the problem, because shaving price differentials is done on such thin margins that it’s difficult to see the cumulative effects of speculative trading. Nevertheless, they saw a statistically significant influence of speculators on prices.

    The past decade adheres to the expected historical pattern: Global demand has been the main driver of oil prices. Our estimation in this scenario shows that global demand explained about 40 percent of the oil price increase within the past decade.

    Speculation was the second-largest contributor to oil prices and accounted for about 15 percent of the rise. The effect that speculation had on oil prices over this period coincides closely with the dramatic rise in commodity index trading—resulting in concerns voiced by policymakers.

    Just as interesting as the rise in the price of oil was its sudden collapse in the second half of 2008. This was driven by the financial crisis and was manifested in two ways: a sharp contraction in demand, due to the global recession, and a decline in commodity index trading, due to diminished risk appetite in financial markets.
    Oil inventory demand played a smaller role in the oil price buildup, though this demand accounted for a large share of the spike from mid-2006 to mid-2008. And oil supply contributed the least to both the boom and bust in oil prices.

    On balance, the evidence does not support the claim that a sudden explosion in commodity trading tectonically shifted historical precedent: Global demand remained the primary driver of oil prices from 2000 to 2009. That said, one cannot completely dismiss a role for speculation in the run-up of oil prices of the past decade. Speculative demand can and did exacerbate the boom-bust cycle in commodity prices. Ultimately, however, fundamentals continue to account for the long-run trend in oil prices. (my emphasis)

    At today’s prices in Maryland ~$4/gallon, 15% less would lower the price to $3.40/gallon. That’s significant to most pocketbooks & wallets. 15% shaved off every person’s non-discretionary spending per month (if they use gas-powered vehicles to commute, or worse, to do their work!) amounts to a heck of an economic hit.

  • Andrew Wilson

    A tank of petrol (sorry) over here costs about £70 now, which is well over $100, so you guys have still got a way to go … :)

  • Joe Canner

    Ann #3: I agree that speculation is an insidious contributor to gas prices. Ironically, however, outlawing speculation would be an anti-capitalist approach that would presumably be anathema to those who are most vociferous about blaming the current administration for high gas prices.

  • T

    You mean that it’s not President ____________’s fault? :)

    The disconnect b/n what Presidents of the US should be held accountable for and what they are given credit/blame for is a laugh or cry reality for me.

  • Rick

    T #6-

    The problem is that people assume more supply (which the current president is seen as not fully supporting) would help bring down prices.

    Likewise, his energy secretary did not help things from his quote:

    “Somehow,” Chu said, “we have to figure out how to boost the price of gasoline to the levels in Europe.” (Politico)

  • TJJ

    Funny how when gas prices went up under Bush, the mainstream media and Democrats blamed Bush and Chaney because of Haliburton and their oil company friends. You mean to nsay that now the president is a Democrat that other, worldwide forces are at play and politicians really have no effect. Wow, who would have thought that!

  • Richard

    @ 8

    Pretty sure the blame fell on Bush and Cheney because of two reasons:

    1) Perceptions that both have a close history with the oil industry
    2) They invaded two nation-states on false pretenses which led to rising demand in global oil consumption

  • Joe Canner

    TJJ #8, I can’t speak for the mainstream media, but I don’t remember personally blaming Bush for high gas prices. In fact, I distinctly remember being rather puzzled by the then-new tendency of the media to report oil prices as an indicator of the health of the economy. At the time it seemed strange to me, because it had never been like that before. Only later did I realize that because of growth in the global economy (particularly India and China) there was indeed a very real correlation (with a fair amount of causation) between the economy and oil prices.

    In any case, that’s in the past. Can we all agree to stop perpetuating the nonsense and agree to neither blame Obama for high gas prices, nor credit him if prices go down?

  • C

    @Joe Canner #5

    Outlawing speculation? How would you even do that???