Why Is Gas So Freakin' Expensive?
Did you know that gas price gouging almost never occurs as prices rise? Rather, it's most often when dealers keep prices artificially high even as their costs fall.
As gas costs rise to $4 a gallon and oil companies earn around $100 billion each year, it's a good time to question what really goes into the price of gas.
The numbers on the gas station sign hide a complex set of transactions. Before gas can power your car, it must be discovered as crude oil, traverse three markets, and be refined from crude into gas.
Inside, we'll explain the three markets, walk you through the role of refineries, and show how oil companies use creative tactics to manipulate gas prices...
The Three Markets: Contract, Spot and Futures
Both oil and gas are traded on three markets: the contract market, the spot market, and the futures market. Each is influenced by different factors and impacts the price of gas at different stages of production. Unlike the futures market, the contract and spot markets are not the kind of markets found on Wall Street; they are informal networks of businesspeople.
The Contract Market
Though it seems like oil companies spend most of their time ruining your day by raising the price of gas, their primary business is exploration. Once an oil company finds a field and coaxes it into producing crude, it takes that unrefined oil and sells to refiners. The vast majority of oil is sold by contracts. A veritable orgy of contracts signed between oil companies and dealers, oil companies and refiners, refiners and independent dealers predetermine the fate of most oil and gas.
Refiners plan their purchasing and refining activity to ensure that these contracts are fulfilled. In exchanged for this privileged standing, refiners charge contract customers a premium.
The Spot Market
Need some extra oil? Got a spare barrel you need to sell today? The spot market is for you. The spot market fills the gap left by the contracts market. When a refiner needs extra oil to meet its contracts, they find people with surplus oil on the spot market. Unlike the contract and futures markets, which trade pieces of paper, the spot market involves the trade of actual barrels.
The best deals are often found on the spot market. Since neither the buyer or seller is locked into a prearranged deal, the laws of supply, demand, and free market are mostly in effect.
The Futures Market
Crude oil is the bees knees of the American Mercantile Exchange. A futures contract might stand for 1,000 barrels of West Texas Intermediate to be delivered at Cushing, Oklahoma. The futures market represents that collective state of the oil market at any particular moment. When you hear reporters talk about the price of oil reaching $100 per barrel, they're talking about the futures market. Because fluctuations on the futures market are driven by information, its prices guide the contract and spot markets.
The people buying and selling futures rarely, if ever, collect on their contracts; a seven year period saw 5 billion barrels traded, of which only 31,000 were ever delivered.
Refineries
Refineries are the temples where crude oil gets Bar Mitzvah'd into gas. Shifts in the refining world over the past two decades have helped ratchet up the price of gas. In the early 80's, there were over 350 refineries, mostly owned by the oil companies. The oil companies didn't see refining as a place to generate profit, but as an integral part of a larger operation.
By 2002, there were only 153 refineries, and most of them were no longer controlled by the oil companies. Refineries are now held privately and independently, and as with any independent businesses, profit is key. It is in the refiner's interests to supply only as much gas as is absolutely needed to stay on the profitable side of the supply and demand curve.
Gas emerging from a refinery is sold at what is known as the 'rack price.' The rack price is the cost of gas to dealers, and it is generally influenced by the spot and futures market. The rack price is also where branded gas begins to exert a price premium.
Branded gas from Exxon-Mobile, BP-Amoco, etc, isn't different from the unbranded gas found at Joe Schmoe's Gas Shack. Still, there are several costs associated with branding gas. The brand name carries a premium, since people might associate it with quality, and not grossly overcompensated executives. Branded gas is also sold under contract, giving buyers long-term stability that can't be duplicated by unbranded gas. Oil companies also add value to branded gas by providing ancillary benefits that command a price premium, like branded advertising and branded credit cards.
Refiner pricing strategies are almost as complex as the mating rituals of the red-sided garter snake. Though refiners want to maximize their profit, they don't necessarily want to gain additional market share. Refining capacity can't simply be ramped up on demand. Acquiring and refining crude oil takes considerable time, leading refiners to take a slow and steady approach to business. First and foremost, refiners care about fulfilling their contractual obligations. Leftover gas can be sold for profit on the rack.
If a refiner's rack price is consistently too high, dealers will take their business elsewhere when their contracts expire. If the rack price is too low, buyers might swamp the refiner, leaving it unable to meet its contractual obligations.
To ensure pricing continuity, refiners used to call each other and share pricing information. Activist judges on the Supreme Court called this "collusion." The refiners, unfazed by the justices, came up with a crafty alternative: publicly posting their rack prices. Somehow, the Ninth Circuit Court found this to be illegal, too. Nobody knows how refiners discuss their pricing arrangements nowadays, but we wouldn't be surprised if it involved a members-only group on Facebook.
Gas Stations
Ah, gas stations. Nourishers of our cars, wellspring of our rage. Gas stations are not all alike. Some are owned outright by the oil companies, while others are leased by dealers who sell only one brand of gas.
There are supposedly nine benefits to being a branded lessee-dealer:
(1) a wider variety of grades of gasoline than unbranded, which leads to higher gross profit margins,There are also open dealers, who sign contracts with a particular brand, but can shift their allegiance whenever the contract expires. Open dealers interface with refiners through middlemen known as jobbers. A jobber will often supply several dealers, and depending on the size of the operation, will sign contracts, or buy unbranded gas either from the rack or the spot market.
(2) access to oil company credit card at no fee,
(3) oil company third party fee discount for VISA and MasterCard,
(4) "subsidies" in the form of soft loans and investments,
(5) marketing assistance,
(6) rebates based on incremental volume,
(7) training and support on how to run a profitable gasoline station,
(8) technical support and station startup design, and
(9) security of supply.
Finally, there are the true independents. These folks shop around for the best unbranded gas price, sometimes aided by a jobber. They almost never sign long term contracts and almost always get their gas from the rack or the spot market.
At the turn of the 20th century, the U.S. had just under 175,000 gas stations. Of those, about 55,000 are run by independent operators. Of the remainder, half are run by open dealers, and the other half is split between company-owned and lessee-dealer stations.
Fixing The Price Of Gas
Oil companies set the price of gas at company-owned stations. What they say, goes. With lessee-dealers, the relationship is more complex.
Lessee-dealers are charged a 'Dealer Tank Wagon' (DTW) price by the oil companies. The DTW price is set either by the oil company's central or regional office, and is driven by both the spot and futures markets. Most importantly, oil companies determine the DTW price by looking at the prices of other stations in the market. This is why two stations with the same brand a block away from each other can have different prices.
Lessee-dealers can't negotiate a DTW price since they sign contracts with just one oil company that require them to purchase a minimum amount of gas. Oil companies allow dealers to sell gas at a slightly inflated margin to ensure a profit stream so the dealers can put food on their family's table. That margin can range from 3-10 cents per gallon.
Why don't dealers just raise the prices more, like 20 cents a gallon, so they can give their families even more food? Some do. If they're caught, you can bet anything the next DTW price will be higher, bringing their profit margins back to normal - only now, their gas is more expensive than their neighboring stations and they have a competitive disadvantage.
DTW pricing is the product of an exceedingly complex and secretive pricing scheme known as zone pricing. A zone can be as small as a single gas station, or as large as a city. The testimony of a Mobil representative in 1997 revealed that Mobil had 46 zones in Connecticut. Most dealers have no idea what zone they are in, even though the DTW price given to their neighboring stations can determine their standing in a local market.
Oil companies, like politicians reapportioning voting districts, rely heavily on technology to slice apart local markets. The DTW price in each zone will be different, taking account several factors including nearby competition, demographics, and the historical demand of the zone. Oil companies also seek to determine the price elasticity of each zone, or how much the zone will pay for gas before looking for alternative suppliers. For some zones, that breaking point is a penny, for others, it two or three cents, and some will stay with their station out of a sense of loyalty. These factors can cause the price of gas in neighboring zones to fluctuate by as much as a dime.
Oil companies adjust zone price by considering what their competitors are doing. The price of rival gas stations will be surveyed two or three times a week, or the data will be relayed to the oil companies by refiners.
Taxes
State and federal taxes account for about 18% of the price of gas. The cost is a constant and is factored into the baseline price of gas.
Eliminating those taxes would reduce the price of gas by a few cents, but would do nothing to otherwise address the underlying factors involved in pricing gas.
Ok... so why IS gas so expensive?
A butterfly flaps its wings in the Saudi desert, causing the State Department to release a warning of increased terrorist activity. The futures market flips out, sending the price of crude skyward. The higher price on the futures market makes it more expensive for refiners to acquire crude to refine into gas. When the refiner's work is done, the emerging gas will be priced accordingly higher. This raises the rack price and the prices on the spot markets. Oil companies and jobbers with long-term contracts might be insulated from the higher price, depending on their contracts. Refining oil into gas isn't instantaneous, and there can be a lag before the higher price of the oil is reflected in higher gas prices paid by jobbers and oil companies. That, of course, didn't stop them from raising prices the moment the futures market jumped. So now that the oil that was purchased for refining at a higher cost is ready to hit the market as gas, the oil companies will raise prices again. This double-dipped price is passed onto dealers as the DTW price, which is then inflated yet again so the dealers can turn a profit. You paid more for gas thanks to a butterfly. "It's just a !@$% butterfly!," you say. Sure, but it scared the hell out of the markets. Since the oil companies all move in lockstep, that butterfly can cause the price of gas to rise for several days as one oil company sees another raising prices and adjusts accordingly. Eventually the markets will calm and the price will begin to fall. This allows the introduction of a friend much more insidious than the butterfly: price gouging. Despite popular misconceptions, price gouging almost never occurs as prices rise. Instead, price gouging occurs when dealers keep prices artificially high in order to gain a little extra profit or recoup costs, even though the DTW price has declined. Sticking with our butterfly friend, let's say she caused the DTW price of gas to spike for four days. It may be ten days before dealers lower their prices. That's price gouging. Most people never notice true price gouging. They will complain that the price went too high, but that's the fault of the oil companies, not the dealers. Prices that stay high for too long go unnoticed. Just because the price of gas stays high does not mean that a dealer is price gouging. The price may actually be higher. That's why it's almost impossible to prove, let alone prosecute, price gouging. Conclusion Unless you're a Saudi Arabian butterfly, you can't hope to control the oil market, but you can control your consumption. Reduce your gas costs by carpooling, biking, walking, using gas price finder sites to decrease the information asymmetry, and/or switching to a car with a better MPG. - CAREY GREENBERG-BERGER RELATED: (Photo: Getty)
Most of the above draws on the excellent work of the Senate Permanent Subcommittee on Investigations, which produced a 324 page report that makes for a fascinating read. Direct links to the report sections are below:
Executive Summary
Introduction
The Production and Marketing of Gasoline
The Effects Of Market Structure And Concentration On Gasoline Prices
How Gasoline Prices Are Set
Get 30 More Miles Per Tank: Turn Off Engine If Idling More Than 10 Seconds
Potentially Insane Ways To Increase Your Fuel Efficiency
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Comments:
Gasoline I can understand. Why the hell is bottled water so expensive?
@tigerjade: I used to live a few minutes from a beach town in NJ and every weekend in the summer, the gas would go up 10-20cents Friday afternoon, and back down by Monday morning. Except it would only go down about half as much as it went up.
thats a really long article for information i kinda already knew....but i did learn some new stuff and it looks like you put some time into so im going to give you a B+. If you have any questions feel free to talk to me after class. There is no Extra Credit available in my class.
@zibby:
read the article on why coke is so expensive, the soft drink not the drug, that should clarify it better. http://consumerist.com/consumer/food/the-history-of-the-pr...
If taxes account for 18% of a gallon of gas, cutting them would be more than "a few cents". On a $3 gallon of gas, that's .54¢. On a 20 gallon fill up, that's over $10. Hardly a few cents.
@zibby: It's to prevent development of water as an alternative fuel source to gasoline. :D
A gallon of milk is cheaper than gasoline though...maybe we should try using milk as a fuel...
I gotta go, patent office awaits.
Price is a function of supply and demand. There are lots of cars and other things with a high demand for gas, and a shrinking supply, therefore the price is high. If you don't like it, stop buying gas, which will reduce demand, causing a drop in the price.
awesome article. My only quibble is that the major branded gasoline is not the same as unbranded gas. true, it comes from the same terminals, but branded gasoline has additives, which increases efficiency and reduces long term maintenance. for some kinds of cars whose engines are engineered with tight tolerances (eg, BMWs), unbranded gas is not a good idea because you need additives to keep the gunk buildup down. there is not a huge difference between the additive packages among majors, though the studies i saw (several years ago) show exxon, mobil, amoco (not sure if their additivers exist or if they just use techron now), and chevron techron are the best/cleanest. i wil occasionally use unbranded gas but you should be sure to use a gas with additives as it saves $ in the long run.
@tigerjade: It's the same way with college towns, spiking gas $0.10-0.15 before and after the dorm move in and move out weekends.
I don't see how it's not price gauging, and it'd take one hell of an argument to convince me otherwise.
poor, poor Americans, have to pay over $3.00/gallon. I feel so bad for you, no wait, I don't feel bad at all. How about the rest of the world paying twice that?? Are you complaining for them?? No, you are too self-centred. I hope you end up paying competitive prices, maybe $6-7/gallon, maybe then you would all wake up. I doubt that but at least the oil companies would make even more billions off you. The easy answer; "Get off the oil, man",
Fascinating stuff, but I do love conspiracy theories! The price per gallon contains 40%(+/-) in tax. Fastest way to raise tax revenues is to raise the price of fuel, eh?! No bill, no vote, its instant! Would it not seem that the Federal and State Governments play some role in pricing. Well placed players in the pricing chain, oil lobby, or whtever club gets this stuff done can do a lot it would seem. California has been fixing a lot of roads since this last big rise began 18 months ago. Hmmm. At least the money has been going to good use here.
Huh. That was a really interesting piece to read through... Gave me a headache, but at least my head is throbbing with knowledge. I suppose I can stop blaming the Illuminati for it all now...
...Or can I...
@GitEmSteveDave: They weren't saying if you cut out all 18% of tax on gas prices. That 18% is used mainly to fund new road, road repair, and bridge construction. If you cut out 18%, where would that money come from?
@rocnrule: Why would we complain for other people when we don't have to pay your prices? Complain for yourself.
@Everyone about price gouging during increased levels of activity in their local market:
The sellers can increase the price right before a large event because the demand of their product will be much higher than normal. It's not price gouging; they have a product, a demand, and persons X are willing to pay the price for the product.
The slowly dropping of the price after-wards is more to be frowned upon IMO.
@moosehawk: I'm not complaining, I'm off the oil. Plus I live in Canada so prices are about the same as you. My point is, you're getting a good deal and if its still too much, then consider walking, or getting a better car.
Summer weekends many Minneapolisites head for the lake country. I live just off the most frequently used route to access the lakes (I-94) and it's almost comical to watch the gas prices rise and fall with the lake traffic. I've seen prices increase about 20 cents Friday morning, then drop back down again Monday afternoon. On holiday weekends (like this Memorial Day weekend) the price hike adjusts accordingly. Isn't this considered price gouging?
Good read. Thank you for this wealth of information Carey.
Shouldn't there be antitrust concerns?
Our prices aren't that bad, but they aren't amazing either...It would be one thing if we were complaing and our prices were like some of the below listed:
Panama - Panama City $2.19
Russia - Moscow $2.10
Puerto Rico - San Juan $1.74
Saudi Arabia - Riyadh $0.91
Kuwait - Kuwait City $0.78
Egypt - Cairo $0.65
Nigeria - Lagos $0.38
Venezuela - Caracas $0.12
Bah. You can barely afford to buy gas for your car anymore. Forget about using it for entertainment purposes like setting things on fire or health applications like getting rid of the crabs. It's a shame.
"Sticking with our butterfly friend, let's say she caused the DTW price of gas to spike for four days. It may be ten days before dealers lower their prices. That's price gouging."
Why is it price gouging? In a free market, there is no price gouging per se. There is only the price that someone is willing to pay. If someone isn't willing to pay the price then the price will drop.
I don't understand why you're trying to absolve the consumer of his responsibility in the free market system. Less than two miles from my house there is a gas station that sells gas for 3.15 a gallon. If I drive five more miles down the road, there is a cluster of gas stations that sells for 6 or 7 cents less.
As to "event pricing", as someone else mentioned, it's all about supply and demand. A gas station with no gas is useless. There's no one to come in and buy the real money makers like Coke or candy bars. In order to mitigate that high demand, the prices rise.
People also seem to forget that the cost to acquire replacement fuel must be taken into account. It doesn't matter if you have the lowest prices in town, if you can't refill the tanks when that current supply is gone, you're out of business again.
Make no mistake, "price gouging" laws are nothing more than a politician's attempt at making you feel like he's actually DOING something.
@rocnrule: Why don't you look into all the programs, such as educational assistance and true universal health care, that is funded with the higher gas taxes, before you open your mouth? I wouldn't mind paying more for gas if I didn't have to pay for health care like I do now. It works out even in the end.
But oh no it's easier to bash than research.
@rocnrule:
I wish we WOULD pay the actual price to get us "off the oil". The federal government currently subsidizes the cost of fuel so the end user never sees the real price.
I also think we need to allow more refineries to be built and allow drilling off the coast of California and Florida. This NIMBY attitude they have has got to go.
I'm also against drilling in ANWAR though. This probably comes from having a wife who works for EPD and explained to me what the REAL plan for ANWAR is.
Not to mention that the cost of a barrel of oil is purely driven by emotion not actual numbers.
And the resone why oil companies make so much money is because we consume so much oil. Their profit margins range from 6-9% - often less than sales tax!
@Buran:
I never said it would be easy. God knows I hate now working for a company in-town instead of 7 miles from my house when it comes to filling up the tank.
But I love the company and the pay raise offset the new cost of fuel. Additionally I get the option to work from home twice a week.
One thing that I have at my disposal that others might not is:
http://www.georgiagasprices.com/
My dad is a truck driver and the fuel prices have hit him especially hard. But he has a laptop and Verizon wireless highspeed so he can actually plan his refueling much better. One website he uses will tell him the gas prices for the next 20 miles so that he can better plan his stops.
What I don't get is this:
Gasoline is not the only thing crude oil is made into. Petroleum is made into tons of other things like plastic. How come we don't see Tupperware prices surge at the same time as gas prices? If the futures market is controlling the price of oil, it should get more expensive across the whole board for everyone who uses it, not just gas refineries.
@Buran: Uh, I live in canada where prices are roughly the same as in the US and guess what??? We have National Health Care and better education so I hardly see the point.
@Toof_75_75:
Lets look at prices from Developed countries;
U.K. $7.25
Argentina - 6.60
Japan - 6.60
Holland - 6.40
Germany - 5.60
It's all about process and capacity. What it takes to convert crude into plastic is much less than what it takes to convert crude into gas. I could probably dig up the specific process. Combine that with no new refineries in the US in 20 or so years and there's simply not enough throughput.
Also there's a very healthy and active recycling community with plastics which I'm guessing (no actual facts mind you) probably offsets some of the cost of acquiring raw materials. Unfortunately, we can't recycle gas yet ;)
@rocnrule: It's all relative. Don't you think many Euros would scream bloody murder if they lost one of their 6+ weeks of vacation or if a few hours were added onto their 35 hour work weeks?
Federal gas tax is 18.4¢ per gallon, states add on ( so do cites.)
Here in the great state of Misery we pay an extra 17¢ per gallon, you folks up in NY pay 31.9¢ extra to the state and an estimated 7.9 cents per gallon in county taxes.
Here (as in most states) all tax revenue goes into general revenue and not some special "lockbox" for road repairs. Usage and license fees are supposed to pay for repair and expansion...
See how much you state is rakin' in:
In the early 80's, there were over 350 refineries, mostly owned by the oil companies. The oil companies didn't see refining as a place to generate profit, but as an integral part of a larger operation.
By 2002, there were only 153 refineries, and most of them were no longer controlled by the oil companies.
This is the only part of the article that you really need in order to know why the cost of gasoline rises steadily every year. If you have a diminishing supply, and a growing demand, the prices will go up. That is all there is to it. Since it is essentially impossible to build a new refinery in the United States due to environmental regulations, there is little hope of an increased supply in the future. The only thing we can hope for is less consumption in order to lower demand. However, given the fact that most people I know drive trucks or large V6 or V8 cars all the time, even with no passengers, that is not likely to happen.
So, either we must loosen or repeal environmental protections in order to build more refineries (bad idea), or we must reduce our consumption (really good idea). How many people do you know who drive SUVs or big honking cars all the time, but could switch them out for motorcycles or little cars easily? I would say that 90% of the people at my office building could drive much smaller cars, save tons of gas, and be better off for it. But they drive trucks, SUVs, and huge sedans instead.
Posting the price of gas in other countries is not a basis of comparison unless you include the amount of tax that is added.
We have low taxes on gas in the US in comparison with the rest of the world. I'd gladly pay more federal tax for a pay off in public transit, however that is not going to occur.
@DeeJayQueue
Again, plastics prices are determined by what they can sell it at, and consumers will not tolerate a 200% spike in tupperware. So, the companies' margins on those products have gotten killed.
GE just sold their giant plastics division because oil prices have essentially made it unprofitable.
Oh, and who did they sell it to? A Saudi company that really doesn't have to worry as much about the rising oil prices.
An excellent read. Thanks, Carey. Way to take Consumerist to the next level.
The price is set by emotion and not supply and demand. Everytime a news source reports that gas prices are going to rise, everyone up and down the supply line is more than happy to oblige them.
A voluntary and permanent moratorium on media agencies offering speculation that fuel prices may rise might be pretty helpful.
I'm sorry, but I still don't understand the concept of "gouging."
There are precious few refineries, and so gasoline is scarce. The gas companies charge what the market will bear.
The FA says:
price gouging occurs when dealers keep prices artificially high in order to gain a little extra profit or recoup costs, even though the DTW price has declined.
But isn't that the same thing as saying that the dealer thinks that the market will continue to bear higher prices, so he keeps them that way until the market stops bearing the high price?
I'm no apologist for big oil, but when I hear talk of legislation to "fix the gasoline price gouging problem," I get the gibblies.
@ MrGuts:
Fortunately, the lawmakers aren't smart enough to make the taxes a % of base gas price. Typically here in the US, it's a fixed # of cents/gallon. For instance, NC's tax load on a gallon of gas is in the neighborhood of 30 cents, regardless of the gas price. In other words, at $1/gallon, the taxes are 30%. At $3/gallon, the taxes are 10%. (roughly) And NC has the highest tax loading in the Southeast (and almost the most state-maintained paved roads in the nation).
Dugg.
I am just really glad that my Land Yacht does not run on printer ink. Have you priced the consumables for an inkjet printer recently. $10.00 for 6ml of ink!
Ink Jet Crtridges - Now that is price gouging. Gasoline - That more of an extra tug on the wallet.
@DeeJayQueue: lusis is correct, but there are other factors in play as well. I used to work for one of the big consumer plastics companies (not Rubbermaid, but one of its competitors) and these companies are very active in the futures markets as well, constantly hedging their risk to avoid sudden price fluctuations. The other reason is that there is no pricing power with these products. If you want a plastic box (or janitor's cart, or trash can or whatever), you get a one - you don't care who the supplier is and the products are essentially fungible. We used to joke that it was like selling dirt.
one thing i don't understand - presumably all of the mechanics of the price setting is the same in developing countries as well as in developed. so what accounts for the huge difference in prices between
Panama - Panama City $2.19
Russia - Moscow $2.10
Puerto Rico - San Juan $1.74
Saudi Arabia - Riyadh $0.91
Kuwait - Kuwait City $0.78
Egypt - Cairo $0.65
Nigeria - Lagos $0.38
Venezuela - Caracas $0.12
and
U.K. $7.25
Argentina - 6.60
Japan - 6.60
Holland - 6.40
Germany - 5.60
???
obviously it's got to be taxes, i.e., community add-ons. also, i seem to recall reading how the US govt subsidizes the gas companies to such an extent that they made collossal, record revenues and income figures in the past couple years. how do we get that stuff removed from the equation?
So is Arco gas bad for my car or what?
@adamondi: You're committing a fallacy. The number of refineries isn't the only number that's significant; individual refineries are larger and have greater outputs. All this number shows is that they are taking advantage of economies of scale. Aggregate refinery capacity has increased steadily, as has consumption.
There is no such thing as "charging the price the market will bear." Firms in the market determine what OUTPUT (quantity, not price) will maximize their profits, GIVEN the shape of the demand curve they face. If their costs rise, they will have to restrict output. If demand rises, they can profitably produce more.
Interesting. But what about when gas stations show a large price jump just before a big event? Down here in and around Concord, NC, the price of gas near the speedway jumped TWENTY CENTS in two days as the fans started arriving. And now that the race is over and they're out of town, gas prices are slowly dropping. And prices in Charlotte maybe just jumped a few cents for Memorial Day, not 20+.
Isn't that gouging?