Why Was Gas So 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 were near $5 a gallon until falling 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,
(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.
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.
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. 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
What Goes Into The Price Of Gas?
Get 30 More Miles Per Tank: Turn Off Engine If Idling More Than 10 Seconds
Potentially Insane Ways To Increase Your Fuel Efficiency
Editor's Note: This post was originally published May 2007. I decided to republish it now because it's one of my favorite posts Carey ever did, and it's incredibly relevant in the current economic situation.
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Comments:
gas has gotten down to about 2.70 in Indianapolis, which is pretty fantastic.
Gas costs $5/gal because people will pay $5 for a gallon of gas and consume it at a rate that makes this profitable for all concerned parties.
We are at $3.29 a gallon, a 70 cent drop. It isn't great but it is better than what it has been.
Great article - I skimmed, and I'll go back and read in-depth later.
This is why I live in the city and don't own a car. I would like to move back to my home town and settle in there, but I'd rather wait for greener cars with better mileage to be affordable and widely available.
@AtomicPlayboy: Actually, gas no longer costs $5 a gallon because people WOULDN'T pay $5 for a gallon, and therefore consumed at a lower rate.
Let's hope $3/gal isn't the new $2/gal for people. Unfortunately, it's almost certain that as a culture, we'll abandon our newfound gas frugality and start driving like maniacs again :(
Thank goodness prices are coming down. Now I can buy the heavy duty pickup and ski boat I deserve!
When I looked a couple days ago, it was $2.69 here. God I love living in OK
its funny how they got us believing 2.50 is cheap. when its less than 2 then it will be cheap. (not really but better)
The 'cheap' station here is at $3.42/gallon.
Still high but better.
I swear I have read this exact same article before. Maybe on Jalopnik?
A better question is why is gas so much cheaper in New Jersey, where full service is mandated by law.
@StankGunner: just in time for me to go back to 3.20+ back in florida, at least it gives me something to look forward to.
@Shenanigans Was Taken: I was right, I had read it before; but it was on this very blog.
Why Is Gas So Expensive? [consumerist.com]
It was posted by the same author on May 29th of last year, which happens to also have been my 30th birthday.
Go me.
@InfiniTrent: Yeah, I was making a general point (which your response further supports), not one specifically tied to the $5 rate. Restated:
Gas costs $/gal because people will pay $ for a gallon of gas and consume it at a rate that makes this profitable for all concerned parties.
@HogwartsAlum: And this is why it was $4 a gallon, because when we got back to $2 no one would complain.
@Triborough: Good question. In Morris County, I've been seeing more and more stations in the $2.80 - $2.90 range.
@Triborough: They have insanely low gas taxes (or maybe none at all, but I'm not too certain in that area).
Gas is cheaper here in New Jersey partially because many of the east coast refineries are located here, and mostly because our gas tax is much less than surrounding states.
@junip: The problem is beyond driving a car though, this is one of the root causes of the shrink ray, among other things.
@Corporate_guy: so true! Gas was just below a dollar a gallon when I started driving. (10 years ago, man that makes me feel old) My parents told me stories of 30 cent gas in the 80's.
They just went hog wild on the futures market - $77.70BBL
Some are singing praises and saying $50 by the end of the week.
The Iranians and the Venezuelans are calling for cuts in production like NOW, but the Saudis are standing pat.
@Triborough: It's also cheaper because the station owner doesn't have to pay for the destruction to the pumps by random morons. A station not far from my house just got an entire pump destroyed when someone drove off with the hose still in their car (the quick release valve...didn't). On a full-service station, that kind of thing doesn't happen.
@Git Em SteveDave loves this guy-->: I get mine pumped for me if I don't feel like getting out of my car...but then I add a tip. We always run higher than everyone else. I guess I could go to Kentucky and pay a better price...but then I have to factor in wear on the car, gas, etc. (It is about a 30 minute drive)
@charlie.evans: Yeah, I think I got it for $2.39 up here in Edmond over the weekend. Hey, does anyone else remember when you could fill up with a ten dollar bill, and still get a buck or two back in change? And that was in 2001.
When I paid $2.99 this weekend I called all my family and friends I was so excited. Honestly though, I don't want it to fall to far. the changes that people and businesses are making won't continue if it gets too cheap, and we need to conserve.
I know a number of companies that decided that at $3.50 a gallon they were better off going to a hybrid fleet. If it drops too far they will lose money on the deal and be less likely to make positive changes in the future.
@AtomicPlayboy: :) True.
Obviously, there's a floor that the price won't drop under, but it's interesting what a mere 5-8% decrease in consumption did to the price!
we just broke $3 here & to be honest, i'm pretty comfortable with that. i know this is going to be an unpopular opinion, but i've enjoyed the noticeably lesser traffic that occurred with the spike this summer.
if prices continue to drop, i fear that many of the conservation tricks we learned this summer - grouping tasks into one trip, ride sharing, mass transit, biking & walking a little farther - are going to be forgotten.
as much as i'd enjoy filling my tank up for $10-15 less, i'd rather see us all be a little more responsible with our gas consumption. those 2 things don't necessarily conflict with each other, but cheap gas breeds bad habits.
Now I'm just enjoying the sour looks of all the new Prius owners who took on a $25,000 car payment just to save some $$$ on gas.
/bitter 1998 V6 Chevy Lumina Driver
@JohnDeere: That is cheap relative to just about anywhere else on the planet. You will never see sub-$2 gas again.
The price of oil is reportedly the lowest it has been in a year. But I remember paying $2.18 a gallon in Feb. 2008 in New Jersey. Today's gas price is still .60 Cents higher. While I appreciate the lower price I cannot understand why people thinks this is 'Fantastic'.
@downwithmonstercable: Yah, but the shrink ray is harder to avoid. The gas pump is easier.
Some of the store-branded items in my local safeway have either avoided the shrink ray, or have taken longer to shrink the product than the name brands have, which is a plus.
I feel really bad for the people who live in cold climates this winter too. Lucky me, I live in a very temperate climate.
Just paid $2.89.
@Triborough: Not being allowed to pump your own gas is UNAMERICAN.
If you have the IQ to operate a machine as dangerous as a car, surely you can operate a gas pump.
Heck, I've done it hundreds of times, and I haven't blown up a gas station...not once!
I guess my comment will be banned because this blog is mainly American. But the truth sometimes hurts.
I can't believe. $5 a gallon?? So freaking cheap?? :D
Ok, I was born in Lithuania. It's small country in Eastern Europe. But $5 a gallon? We had such a cheap gas price probably 5 years ago. I just checked it now. It went down a little bit.. now its $6.24 per gallon.
2 years ago gas price was maybe few cents lower. I was a student. I was driving 30min. to work and back everyday. Usually long trips on the weekends etc. And at that time I didn't thing gas price was expensive. It was not cheap, but not expensive either. (Btw my income was quite low at that time).
Now just bare with me and take into account that average salary in USA is 3 times bigger than in Lithuania. OK, lets just lets say that Americans are bitching when gas price reaches $4 per gallon and goes crazy when gas price reaches $5 per gallon. And an average East European thinks that you can live with the gas price of ~$18 per gallon and if the gas price drops down to $15 per gallon it's just normal price. (take into account that people in USA earn 3 times more then in Eastern Europe, so that's why I put the price $18.
Just for information I want to put down my car statistics. Few years ago I had an old car honda civic of 1994.
3.87 gallon per 100miles in town
and
2.81 gallon per 100miles in highway.
Ok, so now people. Americans, please explain for me how come you bitch and whine so much about gas prices going up to $5??? I understand it's can look not fair and hard when you see some item or service price going up by x2!!! That LOOKS like a disaster. Sure it looks expensive. But is it really so not affordable??
At school for few years I had an English teacher from New York. He was born in USA. And he was ~24-26 years old at that time. From his stories I understand that a car for American people is like symbol of freedom. That no one is ever going to buy groceries without a car (there no ever a question about that), even if you visit your friend 200 metres away from your house, people still take car. Do you really need that??
I think all this fuss is not in a rising gas prices. It's more based in an inner feeling that you might have to change your driving behaver, which might feel like loosing of freedom??
Personally I don't think you loose freedom if you walk small distances instead of driving car.
I don't think you loose freedom if sometimes you take a bike instead of a car.
I don't think you loose freedom if on rare occasions you take bus instead of driving a car.
I don't think you loose freedom if you don't buy a new car every 2-3 years.
Hmmmm.. maybe I'm wrong.
Just think about it.
Peace.
Aidas
So how many fucking butterflies flew over the Middle East this year? Seems to me we had $5 for more than just a few days, so hopefully you're using days as a metaphor.
Also, when will people ever realize gas always jumps way up during the summer, then drops again come autumn? Seems like no one is ever able to figure it out...
Believe it, or not, there is a whole lot of information missing from the above article. I understand the desire to explain things and do some good, but really Gas and oil is not that hard, or that complex. It only *seems* that way to some. (Maybe most, I never took a pole.) Information like who the players are, or that oil companies setup subsidiaries for manipulating the market. Information like how most of the market manipulation is kept secret to benifit the oil companies. If you remember Enron, really you can break it down just like what they did. Power companies actually are still doing what Enron did, but because just about everyone and their Mother is bought off that might have influence in the industry, we all buy their rhetoric and then some. Going so far as to repeat the marketing division's mantra, "Oil Prices Will Never Go Down Again!" Oooo. Now we look like we know something. If someone else repeats it, then we really look like we know what we're talking about.
All you need to know is a couple of things. 1st is that the oil companies and power companies operate in a false market. A market setup to look complex to that average schmuck not willing to do the research. Second that oil and power companies manipulate that market to keep profits up. This last burst of raised gas prices was not because of actual Futures market trading, or the flapping of locust wings, it's because oil companies wanted to secure future profits by opening up restricted drilling. Try watching C-Span and you'll get it. Most people don't, like most people have no clue if their bank is about to fail or not. They just 'hope' it doesn't. The rest is all politics and corruption. What needs to happen is Fuel Cells and put an end to the 'Grid'. I'm a long time 'off roader', but I'd gladly give up all that for an electric car that goes at least 100 miles, rather than pay another dime to oil, gas, or power companies. (I did see an all electric off road motorcycle inside a magazine recently...)
@ai2tis: Maybe you are right about some things, but you need to understand the vast differences in size and public transportation infrastructure in the States versus Europe. There are many times when there simply is no option available to many Americans other than driving, because we have shoddy rail and bus service outside of major cities. Even within many major cities, public transit is a joke.
So while it might be nice to say, "Hey, take a bus or ride a bike to work instead of driving," I would love to see you try to ride a bike the 35 miles each way that I have to drive in to work from my house, because there was no affordable housing any closer than that to my office. Or, alternatively, I would like to see you spend the 2.5 hours each way on the bus that it would take me to make that same trip.
So feel free to get off your high horse and think about the geographical and infrastructural differences between our countries before you go off on how much we complain about gas prices.
@adamondi: That's the think. I want to discuss about this issue.
I'm not on a high horse mate. :)
Ok, I'll take into account USA infrastructure. But the thing is. I know a lot of people who drive a car for an hour just to reach their work place. And even they don't complain about gas prices. They wanted a well paid job with an affordable house outside the main city center. They've done that. It was their choice.
As for "Hey, take a bus or ride a bike to work instead of driving". I didn't say such thing on purpose, because I know that there are quite a lot of people who drive a long distances to work.
I personally was working as a real estate agent for around 6 months. At that time I was basically "living" in a car. Company didn't have policy which would compensate for the gas. And even at that time I was paying Around $6.24 per gallon. I didn't think that gas was expensive.. It was simply affordable. Still keep in mind that salaries are much lower in Easter Europe.
I saw gas for $2.99 today. I was shocked
@ai2tis: You keep saying that salaries are much lower in Eastern Europe compared to the US. I know that if I worked for the US minimum wage, and had to fill my tank once a week to get to work, I'd be spending around 30% of my weekly pay on fuel alone. Is that a a good wage comparison between the US and Eastern Europe?
@Triborough: We have a ton of refineries, are close to where the crude comes in from overseas, and we also manufacture many of the additives locally. Plus, we sell a higher volume of gas because of population density. Also, apparently full-service is just a drop in the bucket compared to the other expenses. The number I hear is two to three cents more per gallon to have someone pump it for you.
I agree that it's not exactly hard to pump a gas tank, but it is convenient to not have to get out of the car, and it's usually faster because the guy pumping the gas knows how to mess with the touchscreen better than I do. Pardon the pun, but YMMV.
@bmoredlj: Not a safety issue. It is a job creation and product/profit saving issue. Helps prevent customer-based ""shrink"".
mmm Deja Vu! is this a recycled post from the past?
Sure looks like it.
I paid $2.59 a gallon this weekend. Gee, it was nice to see a "2" in the price again. Whee! :D