What Determines Gasoline Prices?

Price, Taxes, Inflation, The Supply & Demand

The determination of what causes changes in gas prices is a complicated area of economics. Because of the tremendous demand for gas consumers are highly conscious of pricing and often leap to conclusions concerning what is causing rises in gas prices. In reality there are a variety of factors which determine the price of retail gas in the United States.

One of the largest factors determining gas prices is the price of crude oil. The 2011 cost of crude oil was averaged at 68% of the retail cost. The demand for crude oil significantly impacts the cost of gas. The global demand for oil is in a state of continuous growth which increases the cost of gas annually. According to the U.S. Department of Energy,

The single biggest factor in the price of gasoline is the cost of the crude oil from which it is made. In recent years, the world’s appetite for gasoline and diesel fuel grew so quickly that suppliers of these fuels had a difficult time keeping up with demand (U.S. Department of Energy, 2001).

While the price of crude oil is a large determining factor for gasoline price it is only one factor in a complex relationship including the factors of taxes, inflation, supply, and demand.

One of the largest and most overlooked factors in determining gas prices is taxes. The taxes on gas in the United States account for approximately 20% of the retail cost (U.S. Department of Energy, 2013). The tax factor is partially to blame for the vast differences in fuel costs between geographic locations (Hargreaves, 2012). For example, in 2011 the average cost of gasoline in California was $3.77 per gallon while the price per gallon in Wyoming $3.07 per gallon (Hargreaves, 2012). This large difference in price is strictly due to local or state taxes levied on retail fuel. To understand how taxes affect fuel prices, one need only look at other countries to see this disparity. Most of the industrialized nations of the world tax fuel heavily and this severely impacts the cost. For instance, in Norway the cost a gallon of fuel is between $12 and $13 per gallon (Smith, 2012). In most of Europe prices are double that of the United States. The same gallon of fuel that costs $12 per gallon in Norway might only cost .20¢ in Venezuela (Smith, 2012). These large disparities in cost are due to the fact that many countries that are still developing subsidize fuel in order to encourage business and industrial growth. By controlling the price of fuel in this way, these countries create and artificial supply and demand which reacts to changes in subsidy (Smith, 2012). What is experienced in the United States is not altogether different than this subsidy because the cost of fuel is artificially increased by virtue of taxes. Thus supply and demand can be altered by changes in taxes. The taxation of gasoline is one of if not arguably the largest factors affecting the price of retail fuel.

Taxation is a major factor affecting fuel prices at the macro level but coupled with this factor is inflation. Inflation and taxation go hand in hand and can affect prices of fuel dramatically. The relationship between inflation and fuel cost is a cause and effect relationship. Increases in fuel prices will create inflation. This relationship is due to extreme dependency of the United States on oil. Fuel is a critical need in the United States because it drives so many other industries. Unlike other goods, the price of fuel is not affected by normal factors associated with supply and demand such as price alterations. The price of fuel is so heavily controlled; the inflation which seems to raise retail gas prices is really a result of an artificial inflation. This artificial inflation is the result of manmade issues rather than natural economic fluctuations. For instance, in 2003 the price of oil spiked due to striking workers in Venezuela. The result of the strike was a loss of production (supply) which raised the cost (demand) because of a shortage in fuel. This created inflation in prices which cascaded across several markets. Richa, Kook and Crilley (2012), reflect this artificial inflation when discussing the changes in the CPI (consumer price index) “In 2003–2008, the change in the CPI…for food and beverages was 21.19 percent, whereas it would have been 19.95 percent” if it were not altered by the Venezuela strike. This change in inflation was the direct result of increased oil prices which caused increases not only in fuel costs but in production costs of plastic bottles which are made from oil. This same affect is seen when taxes are raised on fuel prices. Taxes inflate the cost of fuel and thereby increase cost for a variety of industries.

The natural inflation of gas is difficult to determine because it would require that taxes, supply and demand stay constant. The true effect of inflation on pricing is artificial due to this reason. Because of the heavy dependency on gas, the inflation factor for fuel cost is also dependent on many factors such as labor, natural disasters, political issues, etc… To fully understand this relationship one need only study the CPI increase between 2003 and 2008. The CPI rose 19.71% due to natural disasters coupled with shortages and political unrest in oil production countries (Ajmera et al., 2012, p. 36–37).

Higher oil and gas prices therefore accounted for 37.48 percent of the percent change in the all-items CPI in 2008. Rising oil and gas prices accounted for a substantial amount of the inflation both over the entire period from 2003 to 2008 and in 2008 (Ajmera et al, 2012 pg. 36–37).

The cause and effect relationship between fuel prices and inflation can severely impact not just fuel costs but a variety of other costs in other industries. This factor is tied in heavily with taxes due to the artificial increase in price which taxes create. As a result of this relationship, when prices increase the effect of the inflation is magnified because of the heavy taxation on retail fuel.

Taxes and inflation both affect price of fuel dramatically but supply and demand also play a large part in the pricing equation. The supply and demand relationship for gas is slightly inelastic. This means that the price of fuel has little effect on the supply or demand. This relationship has been the cause of a great deal of controversy surrounding gas prices. Many people wrongly assume that sharp spikes in gas prices are the result of gas station owners’ price gouging and profiteering. While this may have some validity the overall increases in prices with fuel costs are often the result of shortages in supply which drive up demand (What Determines Gas Prices?).

This is another area of misconception with regard to fuel supply. When people hear the word ‘shortage’ they often assume this means that there is an actual shortage in oil or gas coming from the wells. This is not so as more often a ‘shortage’ is referring to a shortage in the supply chain. Currently the shortage of fuel in New York was created by Hurricane Sandy (Hu, 2012). The natural disaster damaged the power grid making gas stations unable to pump fuel. This factor created a shortage as less than 50% of gas stations tried to provide fuel for the population. This shortage was further escalated by lines forming bottlenecks in traffic and making it nearly impossible for fuel trucks to reach stations (Hu, 2012).

As a result of shortages such as in the case of hurricane Sandy, the supply lines must increase gas transportation as well as production being increased. This increased demand creates higher costs and therefore higher prices. The classical supply and demand relationship holds true but to the general public it is typically unknown what is taking place and therefore owners of stations are blamed.

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. 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.

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 (What Determines Gas Prices?).

On the demand side of the relationship, there seems to be no lessening of demand despite prices. While demand does affect price of gas, the relationship is mostly inelastic. This is due to the critical dependency on oil and fuel. The demand for gas is directly proportional to the number of people and industries which utilize gas. The expansion of population means an expansion of industry and individual use. As a result, the continued expansion of industry and people continues to drive the demand for more gas (U.S. Department of Energy, 2013).

While the relationship is somewhat inelastic prices do fluctuate with demand. Studies report a decrease in demand when prices increase but this decrease is relatively small. Also the decrease is not much different in the short term as it is in the long-term (greater than a year) (Gratch, 2010 pg. 32). This high demand is the reason that people will wait hours in gas lines as well as continue to pay high rates for fuel. The inelasticity is caused by the incredible dependence that Americans have on fuel. It is not a choice to go to not drive a car for many people due to the need to get to places. As a result of this high demand, fuel prices tend to increase or decrease more often due to other factors such as supply, taxes, and artificial inflation (Hargreaves, 2011).

In the United States, there is little price regulation on the fuel industry but there are other regulations and policies which affect fuel price. Most obviously, taxes are a form of regulating gas prices. The large amount of taxes placed on fuel limit the amount that retailers can charge for fuel and keep the industry highly competitive. There are other policies such as safety and environmental regulations which also maintain control of retail fuel selling (Gratch, 2010). These measures however, do not eliminate the dependency or the issues concerning price of fuel. The current demand for fuel in the United States continues to drive foreign oil dependency and this allows for a great deal of control from foreign interests over the United States economy. While these foreign interests can influence the price of retail fuel, more often than not the changes in price are caused by shortages and rising costs associated with taxes or other normal supply and demand issues.

References

Richa, A., Kook, N., & Crilley, J. U.S. Department of Labor, Bureau of Labor Statistics. (2012). Impact of commodity price movements on cpi inflation. . Washington, D.C.: United States

Department of Energy. (2013). Energy impacts on the us economy. Retrieved from http://www.eia.gov/oiaf/economy/energy_price.html

Gratch, D. (2010). The price of gasoline in the united states and abroad. (p. 32). Sanford: Stanford University Press.

Hu, W. (2012, July 6). Gas lines ease, but shortages and closed stations persist across new york region. Retrieved from http://www.nytimes.com/2012/11/06/nyregion/gas-lines-ease-but- shortages-persist-in-ny-region.html

Hargreaves, S. (2011). Gas: Why i’m paying $4 but my neighbor isn’t. Retrieved from http://money.cnn.com/2011/03/01/news/economy/_price_states/index.htm

Smith, A. (2011). U.s. gas prices are a joke . in norway. Retrieved from http://money.cnn.com/2011/03/10/news/international/gas_prices_worldwide/index.htm

What determines gas prices?. (2011, February 15). Retrieved from http://www.investopedia.com/articles/economics/08/gas-prices.asp