How Gas Prices Are Determined

Gas prices increase every summer, and oil companies report record profits just as Americans are preparing for the summer travel season. The two events — rising fuel prices and increasing travel by Americans — may seem more than coincidental. Fact is, gas prices are based on a combination of monetary and fiscal details: the price of crude oil, taxes, refining costs, and distribution costs.

Source – Energy Information Administration (March 2011)

The Energy Information Administration describes these pricing components as follows:

Taxes: the monthly national average of federal and state taxes applied to gasoline.
Distribution & Marketing Costs: the difference between the average retail price of gasoline and the sum of the other 3 components. These are the costs charged by a local retail gasoline station and include profits.
Refining Costs: the difference between the monthly average of the price of gasoline and the average price of crude oil purchased by refiners. This also includes profits.
Crude Oil: the monthly average price of crude oil purchased by refiners. Crude oil price is the single biggest factor in the price of gasoline.

United States refineries produce approximately 90 percent of the gasoline used in the United States, with about 45 percent of U.S.-produced gasoline coming from refineries along the U.S. Gulf Coast. Less than 40 percent of the crude oil used by U.S. refineries is produced in the United States.

Why gas prices rise

Gas prices rise (or fall) primarily due to changes in the global crude oil market. Prices are also affected by variations in tax rates among states, in addition to refinery issues, and retail gasoline dealer issues like location, rent, and local competition.

Global market for crude oil

The price of crude oil is the main contributor to the general increase in retail gasoline prices since the start of 2009. Generally, a $10 increase in oil prices translates to a 25-cent increase in retail gasoline prices. Crude oil prices depend on several factors including worldwide supply and demand, stability of the distribution network, the value of the U.S. dollar, and price speculation.

Supply of crude oil: The Organization of the Petroleum Exporting Countries (OPEC), a cartel of 12 oil-rich countries, which produces about 43 percent of the world’s crude oil, exerts significant influence on prices by setting production limits on its members.

When the overall supply of crude oil decreases, the world market tightens and price usually rises. Restricting the supply pushes up pump prices by as much as 80 cents a gallon. OPEC countries have essentially all of the world’s spare oil production capacity and possess about two-thirds of the world’s estimated crude oil reserves.
Worldwide demand for crude oil: The United States consumes more oil and refined products (such as, gasoline, diesel, heating oil, and jet fuel) than any other nation in the world.

The demand for crude oil in China, India and other developing countries, however, has risen with their populations, increased trade, growing internal markets, and strong commodity prices. Developing nations are expected to account for nearly half of the global demand by 2015, up from 36 percent in 1996. Increasing demand leads to higher prices.
Interruption of the distribution network: Interruptions in the flow of crude oil through the distribution network can cause gasoline prices to rise, including natural disasters like Hurricane Katrina, the Gulf Coast-BP oil spill, or political instability in countries like Iraq, Libya, Yemen, Saudi Arabia, Venezuela, or Nigeria.
Value of the U.S. dollar: Oil is traded on the world market in U.S. dollars. When the value of the dollar drops compared to other major currencies, producers earn less and compensate by raising the price per barrel of oil.
Commodities market speculation: Speculation in the commodities markets where crude oil is traded also drives up the cost. Financial speculators make money on the fluctuations in prices of commodities like oil by placing bets that the price will go up or down. Some studies have shown that the speculative interest in crude oil markets has doubled, from 18 percent to 36 percent from 2003 to 2009.

Speculative activity creates a cost premium estimated at about a fifth of the oil price or 20 cents of every dollar spent on gasoline. The U.S. Commodity Futures Trading Commission and the U.S. Department of Justice regulate and investigate speculation and illegal market manipulation in the crude oil market.

Tax impact on price at the gas pump

Federal, state, and local government taxes are the second largest part of retail gasoline prices. Federal excise taxes are approximately 18 cents per gallon, and state excise taxes averaged 22 cents per gallon at the beginning of 2011. As of January 2011, 12 states levy additional state sales and other taxes on gasoline.

Oil refining requirements and costs

Refiners typically earn about 20 cents for every gallon they process. Refiners lose money when plunging prices require them to sell gasoline for less than the crude oil they bought. Refining costs and profits vary due to the different gasoline formulations required in different parts of the United States.

To comply with the Clean Air Act, refiners must switch to summer blend formulas for many urban markets on or around May 1 each year. Such blends are more complex and more expensive to make. Many contain ethanol, an alcohol mixed with gasoline to create a cleaner fuel that can account for up to 15 percent of some gasoline blends.

How your local gas station profits from gas sales

Retail dealers earn approximately 14 cents on every gallon of gasoline sold. Dealer costs include wages and salaries, benefits, equipment, lease/rent, insurance, and other overhead. An individual dealer’s cost of doing business varies depending on location and number of local competitors.

Stations next to each other may have different traffic patterns, rents, and sources of supply that affect their prices. Gasoline often costs more in wealthy neighborhoods, because stations pass along higher real estate costs. Credit card companies also earn 2.5 percent of the transaction cost as opposed to a flat fee, which impacts dealer margins.